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Consider a market maker that has decided to try to make a round-trip trade in stock A in order to capture the bid-ask spread.

Assume furthermore that he has no current inventory in the stock A. To further simplify things assume that he wants to trade only one share in stock A.

The market maker now has to choose in which order he should submit the orders needed to complete this round-trip trade:

  • Strategy I: Submit a buy limit order, wait for a match then submit the sell limit order and wait for a match
  • Strategy II: Submit a sell limit order, wait for a match then submit the buy limit order and wait for a match
  • Strategy III: Submit both the buy and the sell limit orders directly and wait for matches

Does strategy III strictly dominate strategies I and II? Under what circumstances would a rational market maker want to use strategy I or II rather than strategy III?

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@knorv -- With no holding of A how does trader implement strategies II and III? –  Richard Herron May 24 '11 at 13:15
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@richardh Short selling. The market maker gets the locates from his sponsoring broker. –  chrisaycock May 24 '11 at 17:03
    
@chris -- I am familiar with short-selling, but are short-selling costs worth the few bps on capturing the spread? Maybe thats the real question here? –  Richard Herron May 24 '11 at 17:18
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@richardh Intra day short sells (short sells that are netted against a long position before the end of the trading day) are often provided for free by the sponsoring broker. This holds even for a lot of retail brokers. Since the market maker can be assumed to close all his positions by the end of the day short sells are literally free. –  knorv May 24 '11 at 18:14
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@richardh Intraday margin is very different. As @knorv states, there usually is no cost because we go flat every night. Our sponsoring broker earns its money by taking a cut of the rebates that the exchange pays us as liquidity providers. –  chrisaycock May 24 '11 at 20:04
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3 Answers

up vote 8 down vote accepted

Market makers place quotes on both sides (ie, the bid and the ask). Depending on the market, the MM might even be contractually obligated to provide liquidity within some threshold. NYSE's designated market makers (who replaced the specialists a few years back) are an example. Even when there is no explicit requirement, the MM will quote both sides and simply shift (or skew) the quotes in the direction of the desired trade.

For example, say the MM is bullish on a stock whose midpoint is USD 50.25. The MM might bid 50.24 and ask 50.35. This of course glosses over issues like volatility or liquidity of the stock, both of which will cause the spreads to widen or tighten.

The only time I can think of that an MM would quote only one side is if it can't possibly take-on more of an existing position, like in position limits or when trying to exit at the end of the day. An MM who doesn't want any exposure simply won't provide quotes on either side.

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Assuming that:

  • limit prices of Long and Short orders are equally pre-calculated in all 3 strategies;
  • there is no risk-free return;

strategies 1 and 2 have equal quality, and strategy 3 is slightly better.

However, the only advantage that strategy 3 takes over 1,and 2, is better location of the orders in the price level queue. In case of FIFO (price-time priority) matching algorithm, the second order will be closer to the market, and execute with higher probability. In some instruments this delta can negligible, in others - important.

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