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Market makers provide liquidity to the market by quoting bid and ask prices for most of the time. The pricing in absolute terms is not as important as finding relative mispricing. The market microstructure is often used to develop trading strategies.

Market makers have to deal with two opposite forces

  • on the one hand if they accept to provide liquidity at the bid and ask (ie to seller and buyers) continuously, they should make a lot of money while gaining ask minus bid.
  • on the other hand if the price move while they provide liquidity to the market, they may loose a lot of money.

In short: they like when price do not move.

The bad news for market makers is conditionally to a price move, they will systematically be in the bad direction:

  • if the price goes down (they will be hit at the bid), they will have bough (high) and now the price is low
  • if the price goes up (they will be hit at the ask), they will have sold (low) and now the price is high

this is called adverse selection.

See chapter 1 of C.-A. Lehalle's lecture at Stanford for details.

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