If I have a market maker which is compelled to provide quotes on both sides of the market, I am exposed to risk of quadratic losses (vs my linear gains during normal operations) during times when the market is trending.

Therefore it is imperative that I know when to 'get out' of a bad position just before the market starts to trend.

Assuming I have a signal which gives me a signed prediction for number of ticks of the next movement, how do I build such a warning mechanism?

  • $\begingroup$ If you have a reliable signal, that tells you the price will move by more than 1 tick up, you just go and buy everything below the predicted move for up to your portfolio constraints. Not sure, what's your problem. $\endgroup$ – LazyCat Feb 6 at 18:08
  • $\begingroup$ could you explain the quadratic vs linear comment a bit further please. I dont get it at all $\endgroup$ – Permian Feb 6 at 20:08
  • $\begingroup$ @Permian Market-marking relies on mean-reversion during which you will typically make profits by buying and selling within a range. When you find yourself holding a position on the wrong side of a breakout, your losses will be quadratic because the resulting move tends to cover a much larger range than you've been trading. Moreover if you keep selling into the move, your situation will worsen. $\endgroup$ – wildbunny Feb 6 at 21:25
  • $\begingroup$ @LazyCat That's fine if you have the chance to do so, but big moves tend to come very quickly in the market I'm trading. Moreover, I'm trading a 1 tick market which makes it very difficult to get out using limit orders should you find yourself on the wrong side of your signal. $\endgroup$ – wildbunny Feb 6 at 21:27

If your signal is good then you can cancel your orders on the side the signal indicates when it is big enough

  • $\begingroup$ What if you are already in a heavy position? Simply closing the position on strong signal could lead to death by a thousand cuts if the market then reverts post close instead of continuing to trend $\endgroup$ – wildbunny Feb 6 at 14:44
  • $\begingroup$ You should never put yourself in a situation to hold a larger position than you are ready to hold. There is no magic bullet. $\endgroup$ – Ezy Feb 6 at 20:02
  • $\begingroup$ Do you just employ a stoploss to cover those situations where you're at maximum permissible inventory when the market moves against you? $\endgroup$ – wildbunny Feb 7 at 7:51

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