Tim Olson
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description, tags
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| Captures the bid-ask spread by posting passive limit orders at the bid and ask, using short-horizon directional signals to stay on the correct side and avoid adverse selection from informed order flow. |
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Market-Making
Section: 3.19 | Asset Class: Stocks | Type: Market-Making / High-Frequency Trading
Overview
Market-making captures the bid-ask spread by simultaneously quoting to buy at the bid and sell at the ask. The strategy profits when order flow is uninformed ("dumb"); it loses money when order flow is "smart" (informed/toxic) due to adverse selection. Practical implementations use short-horizon directional signals to stay on the correct side of the market, often augmented by longer-horizon signals to handle adverse selection on individual fills.
Construction / Signal
Simplified rule:
Rule = { Buy at the bid
{ Sell at the ask (359)
Practical refinement — short-horizon signal: Maintain a signal indicating the likely near-term price direction. Place limit orders such that:
- If signal indicates price increase: buy at the bid (stay long side)
- If signal indicates price decrease: sell at the ask (stay short side)
Combined short- and long-horizon signal approach:
- Short-horizon signal: indicates near-term direction; used to route passive vs. aggressive orders.
- Long-horizon signal: provides directional conviction; can justify accepting adverse selection on individual trades if the trade is based on positive expected return from the longer signal.
- If both signals agree: consider aggressive (marketable) order instead of passive limit order to ensure fill.
Entry / Exit Rules
- Entry: Post limit orders at bid (to buy) or ask (to sell), sized to the desired position.
- Exit: The opposite-side limit order fills (completing the round-trip), or a signal change triggers cancellation and replacement of orders.
- Position limits: Must be defined; the strategy should not accumulate large directional inventory.
- Queue priority: Must be #1 (or near front) in the limit order queue at each price level to ensure fills; this is what makes speed/infrastructure critical.
Key Parameters
- Bid-ask spread: The primary source of profit per round-trip
- Signal horizon (short): Milliseconds to seconds; used for order placement direction
- Signal horizon (long): Minutes to hours; used to tolerate adverse selection
- Cents-per-share target: Realized P&L in cents per total share traded (including both establishing and liquidating trades)
- Inventory limit: Maximum tolerated directional position before reducing quotes
- Speed/latency: Infrastructure speed is critical for queue position in high-frequency market-making
Variations
- Pure passive: Only post limit orders; profit entirely from spread capture; maximally exposed to adverse selection
- Mixed passive + aggressive: Use longer-horizon signal to occasionally place aggressive (market) orders when signal strength justifies paying the spread
- Multi-level quoting: Quote at multiple price levels across the order book
Notes
- In a market with mostly uninformed ("dumb") order flow, pure market-making is highly profitable; in a market dominated by informed ("smart") flow, adverse selection erodes all profits.
- Adverse selection: smart order flow tends to arrive when the market is moving against the market-maker's position (e.g., buys come when the price is declining through the bid).
- The "cents-per-share" metric (realized P&L in cents / total shares traded, counting both establishing and liquidating trades) is the standard performance measure.
- High-frequency trading (HFT) infrastructure is key: speed determines queue priority for limit orders, which determines fill probability.
- Long-horizon signal typically has lower Sharpe ratio but higher cents-per-share than the short-horizon signal.
- This strategy is primarily relevant for professional trading operations with direct market access and co-location infrastructure.