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Suppose you are a market maker. So you put a limit price out and hope someone will cross bid/ask spread to take your limit. But there is risk that bad news could come out and market will gap. So your limit gets hit ( price goes right through your limit ) and you are stuck with immediately loss due to market gaping.

Is this the main worry of the market maker ?

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At the risk of stating the obvious: market gaps are a problem only when the market maker is holding a position and the market gaps against them. So the gap problem is really an instance of a more general problem: inventory management.

The market maker's goal is to profit from the bid-ask spread. They prefer to be flat, but at any given moment, they could be holding some inventory, waiting to unload it. The market can go against them at those times. It could move slowly or it could move quickly. But if the market makers cannot unload their inventory profitably, they'll lose everything they gained today ... or more. In a gap market, the probability of unloading inventory profitably falls dramatically.

In short, inventory management it critical for risk management.

My market maker friends say they are "picking up pennies in front of a steam roller." They make a little profit on each transaction; they get crushed when they're holding inventory and the market moves against them.

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A previous responder says "market gaps are a problem only when the market maker is holding a position and the market gaps against them." This is for sure a risk, but not the only risk.

There also can be a problem if you don't hold a position and the market gaps. Suppose you hold no position on Sept 11, 2001 but you have limit order to buy. You are waiting for someone to hit your bid. But then planes hit twin towers. Your bid is filled at limit. Market drops 1000 points right through your bid, filling you in process.

In bid situation you risk downside risk and no upside. In holding inventory you risk downside risk but can gain in upside swing. You cannot gain in upside swing if no inventory and waiting on bid - in this case market runs from you.

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  • $\begingroup$ In that situation, we say the market "traded through" your bid. It's still a problem in inventory management: you acquired the inventory, then the market moved against you. You are describing a special case of the general problem. $\endgroup$ – pteetor Nov 22 '13 at 2:15
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    $\begingroup$ @pteetor, sounds to me you are describing the "chicken or egg problem". Sure most all risks in this space can be traced back to improper inventory management. But I think what smyoo describes is yet a risk that truly has little to do with inventory management. In his example there is nothing you can do or could have done better other than not having provided liquidity in the market in the first place which is easy to say in hindsight. Inventory management in this example is really not the issue imho. $\endgroup$ – Matt Nov 24 '13 at 14:00
  • $\begingroup$ @MattWolf Thanks. Your point is well taken, and I am likely over-generalizing. I suppose I'm reacting to the OP's question: "[Are market gaps] the main worry of the market maker?" My opinion is that inventory management and liquidity issues are much larger problems than, say, competitors, connectivity issues, or price-model risk; and that market gaps are a cousin of those larger problems. $\endgroup$ – pteetor Nov 27 '13 at 19:58
  • $\begingroup$ @pteetor, maybe someone else can chime in but I would identify gap risk as the major risk in providing liquidity in general, unless we are talking about highly illiquid stocks and/or stocks that trade at 2-3 levels throughout the whole trading session. Properly managing inventory to high frequency trading is like the necessity for humans to walk in order to go to work. Not being able to intelligently manage inventory should by default disqualify one to even participate in this advanced trading environment. $\endgroup$ – Matt Nov 28 '13 at 0:21
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The larger fear is always trading against a more informed player than yourself. Informed=right knowledgeof market direction +willingnessto act/react timely to capitalize on momentum. This includes taking into account unexpected volatility of flash crashes, news announcements, etc.

In your example, yes, it is possible to already hold a position on your books OR be obligated to hold a position (resting limit order, minimum avg daily/monthly volume requirements, etc), and then get caught in a sharp price move, resulting in individual trade losses. But part of inventory management that @pteetor eludes to requires that you strategically hold losing positions until you can offset them at a net gain (see loss leadership). So it is common for market makers (stated or de-facto) to use some sort of cost averaging so that they spread the risk out over several trades. Maybe this screenshot will help illustrate: enter image description here

In theory, it is unlikely that the market will go to "ZERO"; so the fundamental value must eventually revert. But remember SNB? It's the holding of the positions in between reversions that could be "scary" and requires proper risk management.

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