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market maker market making

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for the lone-trader - what courses don't teach

Any topic can be discussed from many perspectives. This article is presents aspects critical to lone-retail-traders. A novice tennis player wouldn't enter wimbledon competition and expect to succeed against roger federer, and if a novice stands in his way, so be it. The what, the how, and when, of market-making. Known facts together with implied facts, reasonably deduced from known facts. In the absence of information published in the public domain ...

A market-maker is an essential market participant. Lone-traders need to understand that market-makers do exist, and comprise a substantial part of the daily market activity. They are not there to make a loss or simply hand money to the lone-trader. The market-maker is much larger than a lone-trader who can unwittingly be seriously hurt if they don't understand the actions of the market-maker. Sub-components include (a) market-making (b) market-makers (c) purpose (d) benefits (e) what they do (f) how they do it.

practical implications for the lone-trader

The market-maker is an overwhelming presence in the SPI200 Futures Market. For long periods of the day session, and for the entire night session the market-maker is the market-depth. Both sides. If you wish to succeed - you need to know how to detect it. Try not to trade against the market-maker.

the only dancing elephant in the room

It is possible for the market-maker to be involved in every single trade for the day.
They can be responsible for the entire action for the day.

It's said - to be successful in trading futures, one needs to "think like a market-maker".
To play this game and avoid getting trampled one needs to know about the elephant.

what it is and how its done

definitions

investopedia
A broker-dealer firm that accepts the risk of holding securities in order to facilitate trading in that security. Each market maker competes for customer order flow by displaying buy and sell quotations for a guaranteed quantity. Once an order is received, the market maker immediately sells from its own inventory or seeks an offsetting order. This process takes place in mere seconds.

chigago mercantile exchange
An entity with trading privileges on an exchange with an obligation to buy when there is an excess of sell orders and to sell when there is an excess of buy orders. In the futures industry, this term referred to floor traders or locals, who, in speculating for their own account, provide a market for commercial users. The futures exchange will compensate the market-maker taking on the obligations and risks of enhancing liquidity.

functions

Market-maker's role is defined as an obligation to
• create a market
• provide liquidity
• maintain an orderly market
• provide transitional facilities
• maintain activity

Market-maker's activities are categorised as
• what they do
• how they do it (the mathematics) reference 1
• how they do it (the process) reference 2
• the effect of what they do

Market-making actions, advantageous to larger participants, can be dis-advantageous to lone-traders.

Market-Making algorithms for Price-Setting University of California, San Diego.

Example.
Trades can occur only when buyers and sellers both agree on price at the same time. However, large institutional orders rarely happen in pairs. They need help. A large seller may appear in the "am" session whereas a compensating buyer may not be available until the "pm" session. The market maker temporarily takes the positions off the seller and sells them at a later time. Or, they may be disposed quietly, over the remainder of the day. In performing these transitional duties, the market-maker acts as facilitator, providing a temporary holding pond, or reservoir. A reservoir being a place where something is collected and stored for later use.

The value of this is liquidity. The institution can confidently sell, knowing there is a market, without unnecessarily depressing the market for a long period of time, and the buyer can subsequently buy without lifting the market excessively. Thus the market-maker maintains an orderly market, keeping it aligned with the physical market value.

Securities and Exchange Commission [release No. 34-49582]

The above SEC article defines in detail the requirements of the "clearing house" in respect to maintaining segregated accounts for "proprietary accounts" and "professional accounts". It remains silent on "why" this is necessary. In the absence of the missing "why" detail, "reasonable conclusions" may be drawn.

It is important to understand that in legislation and regulation the following is true.

• If a regulation doesn't rule something out, it can be done.
• If it isn't ruled out and there is any advantage, it will be done.
• Regulations often create unforseen loopholes which "will" be taken advantage of. Count on it.

zero-profit market-making

There are two types of market-making.
Depends on whether the market-maker has exclusivity or competition with other market-makers.

• Zero-Profit market-making. non-monopolistic. [reference 1].
• For-Profit market-making. monopolistic power.

privileges

Unable to discover much about the privileges extended by exchanges other than that given above by the CME.
See market depth, discussed below.

Market makers do not pay
• brokerage
• exchange fees
• margin deposits

who are the maker makers

In Australia
• a list of market makers specialising in the Options Markets is published by the ASE.
• a list of market makers specialising in the Futures Market is not published by the ASE.

naturals

There are periods when there are no "naturals" in the market, leaving it entirely to the market-maker.
Why this happens, and the significance is explained in the solutions section below.

There are times when the physical market becomes idle. Moving less than one point in 15 minutes.
During these periods the future can be seen to move away from the physical, and then return.
It's not in the interest of the exchange for the (futures) market to become idle.
As the market-maker seeks buyers and sellers, the future has to move away from the physical to find them.

It can be deduced

A market maker can buy and sell to itself, a zero-profit event, creating an appearance of activity, with
• High volume over a small range, or
• Light volume over a wider range.

Periodically the Future can fluctuate over a "reasonable" range on low volume, when naturals are absent.

During periods of low activity, with no naturals (in market-depth), and the market is at or near a technical support or resistance level, the market-maker has the power to precipitate a false break out, by simply moving price outside the level, (seeking volume ie price discovery) on small volume, and within the parameters of price discovery and keeping the market moving. There is nothing to say they have to stay inside the "technical" boundaries. Remember the regulatory comment above. If it isn't ruled out, it can and will be done. This can spook a "natural" to go to market with a moderate sized order, which, (given the thinness of the order-book) "sweeps" the market multiple price levels, which in turn triggers stops sitting just outside the "technical" boundaries, thus creating a momentary stampede. Remembering the thinnness of the market, the extent of the move can become exaggerated. The extremity of the move is caused by naturals and not the market-maker, who of course, is the "taker" on the other side of the rush. After the rush, the future returns to its balance point, the physical cash. Where the market-maker exits the positions obtained at the extremes.

market depth order book

Exchange-trading-platforms accept and manage orders up to 200 points either side of the market. Many exchanges release 5, 10, or 15 levels of depth to the external retail market. The exchange is aware of the total order-book. It "should" be assumed the market-maker has access to this "full" depth, as a necessity to discharge its obligations, and a privilege in exercising its for-profit market-making activities. Discovery of where supply exists and doesn't exist becomes a simple programming exercise. Determining when weak shorts or weak longs have been exhausted is also a simple exercise.

Broker supplied trading platforms, resident at the brokers site, can manage iceberg orders and stop orders. It should be ascertained whether the broker-supplied trading-platform manages them off-site, passing them on to the exchange only when triggered, or on-site at the exchange platform. If passed straight through and resident on the exchange platform, it "should be assumed" the market-maker has access to them. Regardless of where they are positioned. Which is the main drawback with unregulated Forex and CFD markets where the issuer/provider is both the market-maker and the exchange.

Reference [1] below explains how the market-maker's algorithm uses the market-depth order-book to derive pricing. The volumes available in the order-book are at maximum at the open. Which ties in with
• hitters and sitters
• monopoly advantage

related topics
pre-open monopoly time
market depth
hitters v sitters
solutions

robots in a trading environment

Bandwidth - a market-maker's privilege.
One article on algorithm development discusses data speeds. Prime-brokers are moving their data-centres as close to the exchange as possible as speed is critical. Nano-seconds are vital. Network connections from the exchange are arteries with veins feeding off to data-vendors, brokers, traders etc. The main pipe (artery) or backbone is 1mb speed/bandwidth while distribution veins are 500kb speed/bandwith. Data is transmitted as packets down the main pipe. With natural latency, a 1mb connection at the front of the network has first access to data, while the furthest 500kb connection has last dig at the data. When dealing in nano-seconds, if the market-maker is at the front of the queue with a high speed connection, detects a sudden move in the underlying instrument, they, the market-maker is able to react and move their order away, or withdraw, before the last in the queue even knows about it. With any reticulation system, the further from the source, the service diminishes. One privilege exchanges can provide is to allocate first connection to the market-maker. While the market-maker cannot "see" packets of other traders passing through, they have first access to any changes in the physical index, and changes to the market-depth not generated by themselves. Have seen it happen. Observed that one night on Sycom. There were 10 on the offer, 5 points above the bid. One lot tried to hit the offer. The offer disappeared, the re-offer came back 1 point higher, with a re-bid at the previous offer price. The market-maker was able to move the 10 offer, instantly. The three data transactions happened simultaneously. The very best retail software and hardware cannot beat this.

Institutional Trader response - 14 March 2008
Well I just got done by one of these today. Working an OTD buy order in a stock. Initially I noticed the bot because it was constantly placing 100 to buy in front of me if I put anything on the bid. I put in a bid at 150, it put on 100 at 151. I go in at 152, it goes in at 153. Forcing me to hit the offer. So I did. There was 800 shares on the offer. The 800 was composed of 1 parcel of 600 and 1 of 200. I entered an order to buy 800. Theoretically I should get that entire 800. The difference in execution time between the 600 and 200 should be a nanosecond. Or less. I got the 600 but the parcel of 200 disappeared before the remainder of my order was executed. So someone/something was quick enough in the nanosecond between the first lot of 600 being done and the time the second lot, to pull the 200 order. This begs the question: If I was wanting to, for example, negatively influence a stock, and I had the capability, I could stick 10M shares on the offer. Composed of 2 orders. 1 of 1000 followed by 1 of 9,999,000. If someone steps up to hit me, as soon as the 1000 (or 1 or 10 or 100) is done, the remainder automatically disappears. I get all the benefits of the downside pressure, with no risk of someone hitting me and me being short when I really don't want to be.

They are in about 90% of stocks now. Little bots, working away.

flash orders

August 2009. It now emerges high-frequency-trading algorithms can pay the exchange a fee to obtain a peek at orders coming down the pipe. The exchange flashes incoming orders to fee-paying users. Flashes last for 3 nano-seconds. Mary Schapiro of the SEC is currently looking at it. In the meantime thats whats you're up against.

blackjack - an algorithmic digression

Use of Technology
In the topic on probability "blackjack" is discussed as a training tool and the advantage of high cards. The distribution/incidence of high cards is important. The worst case is where all cards are evenly distributed throughout. Since year 2000, casinos began introducing automatic electro-mechanical card sorters. (Shuffle machines). The machines are controlled by a pre-programmed circuit board using rules that achieve a sorted outcome. A recent feature has been the arrival of continuous "shuffle machines" which are fully enclosed. You can't see anything being done. Achieving amazingly consistent even card-distribution. Suggesting the electronic shuffle machines use "OCR" (optical character reading) to detect and sequence the cards. OCR is 1980's technology so it's not new. The regulations governing blackjack do not rule out the use of electro-mechanical sorting machines, remaining silent on the technology used. So if it's not specifically "ruled out" the probability is, it's in. If they can, they will. Why wouldn't they.

Principles of card sorting invented by Herman Holerith in 1900, the foundation of IBM.

margin effect

Beginning 2007 regulated exchanges increased margin requirements, affecting the overnight carrying capacity of [small] participants. Market behaviour in the closing phases of the day-session changed.

when the market-maker gets overwhelmed

Occasionally in a strong running market, opposing robots can punch through so quickly, slow time-release icebergs can't stem the tide, resulting in a blow-off. The market-making robot gets overwhelmed becoming trapped with a lot of inventory that is now under-water, in turn creating conditions for a predictable event in the last half hour as the elephants head for the exits. This can happen, and occasionally does happen, see robots out of control

market-maker's advantages

In addition to the privileges granted by the exchange, the market-maker enjoys a number of natural advantages which are a by-product of its size and weight. Characteristics native to its trading and net inventory position.

the market-depth puzzle

No prizes for the right answer

Placed a 1 x lot limit buy order 20 points below the market
The market traded down, the required price hove into view, at level 5. There were 30 lots on the bid.
That meant my order is one of the 30. I assume I'm at the back of the queue, with 29 in front.
There are also 30 on the bid at each of the higher levels 1,2,3,4.
Price trades down further. My buy level raises to level 3. There are now 40 on the bid.
29 in front and 10 behind.
Price trades down further. My buy level raises to level 2, with 50 now on the bid.
29 in front and 20 behind.
Price trades down further. My buy level is the front level 1, with 60 now on the bid.
29 in front and 30 behind. I am in the middle of the queue.
The higher 4 levels of 30 got taken out cleanly and quickly.
A seller hits the 29 in front of me, leaving 31 untouched.
The market then reversed. I didnt get filled. That was the low for the day.

First time it happened I wrote it off to experience.
Next time I wrote it off to amazing coincidence.
Next time, and the next time and the next time .. wasn't coincidence.
Happened too often. What was the answer? What was happening?

Think that through in terms of the foregoing notes and you will understand.

There are 8 critical pieces of information there.
Analyse it, pull it apart, arrive at conclusions. The beginning of tape reading.
Another term would be "how to detect zero-profit fictitious trading"

When there are no "naturals" in the order-book, the market maker can move price at will, at zero cost.

solutions

Our software analysis engine enables users to identify when the market maker is active.
Our client documentation explains how to observe when the market-maker occupies the visible order book
Our client documentation explains how to observe when naturals are active in the visible order book.

Solutions enabling clients to observe market-depth with a greater understanding of what's happening in the order book.

references

1. effect of market-making on price Dept. Computer Science and Engineering, University of California.
2. dynamics of price discovery Dept. Economics, University of Washington Seattle, 73 pages.
3. monopoly power of the market maker Dept Finance Economics, University of Sydney, NSW, Australia.
4. opening call pre-market auction discusses [3] and how the market maker uses market depth to set the opening price.
5. iress technology market making component sfe and asx - available software - what can be done. 2005

footnote. web-iress is a subsidiary of www.asx.com.au

identifying the market maker

alternately - how to identify when naturals are present - either side of the market.

the first step in dealing with robots is recognising them

Examples and explanations not found or provided anywhere else

understanding market-depth

Market-Depth represents the quantities available in the market at any given time. Comprising three groups of participants. A market-maker, some locals, and naturals. Locals can perform much the same function as the market-maker. A natural is anyone else, including hedge-funds, arbitragers, retail-traders and lone-traders. For long periods of time the market-maker is the only occupant of both sides of the market-depth. Evidenced by the absence of naturals. When the market-maker is the only "offeror" is important to short-term traders and un-important to TA practitioners and position traders.

Understanding this can be advantageous to short-term lone-traders. Entering the market when naturals are absent from the order-book can be an anxious time because you will be on the other side of the market-maker who is not going to give you a free ride and hand you money on a plate. More than likely the market-maker will move against you immediately and test your resolve. Understand one thing. The market-maker knows at all times how much of the order-book they comprise.

differentiating between market-maker and naturals

Observing the composition of the order-book is straight forward. The required data is available in the market place continuously. It just requires knowing where to look. And what to look for. Simple know-how.

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Published May 2008

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