So roughly, the idea is that if I’m smart money (say a big hedge fund or institutional trader), behind any of my trades is an implication that I know something worthwhile. So my trades will move the market, and this can leave market makers holding the bag if prices move quickly.
But if I‘m the proverbial dentist, my trades are just noise that don’t signal anything real about the market. I can get better execution because market makers aren’t worried about my trades moving the price out from under them.
Although Im sure the improvement isnt that significant per trade, is it worth trying to game this to lower my toxicity, i.e. use odd lots, break up my trade etc?
You are putting it almost exactly how Matt Levine puts it.
I would just sneak in the point that, to my understanding --- and the previous commenter would know better than I do --- one of the big information advantages institutional traders have is simply the knowledge that their order is the first of 1000 identical orders they're about to follow up with.
Yes, this is also a good point. Retail trades are more likely to express real demand. When a retail traders puts in an order for 135 shares, say, it's most likely that's an accurate and complete signal of that traders intentions: they are looking to buy 135 shares. For institutional players, it could be an iceberg order: once the 135 shares are filled, the refill the order with another 135, again and again. So the actual orders they submit are less representative of their actual intent, making handling their trades much more risky.
What's the specific risk when handling these trades? Is it that the quoted price should be higher, given that there is more demand than there seems to be?
If that's the risk, though, it's not a risk of loosing money you have, but rather a risk of not making as much money as you could by selling at a higher price, right?
So let's say I'm quoting a tight spread and a small buy order comes in and I get hit. No problem. I don't adjust my quotes because that small of order will not impact the price. But now more orders are coming in from the same institution, buying more and more (basically one big meta-order broken up into small orders so as to conceal intent). If I don't realize that all of these small orders are from the same institution and that they actually represent one big order, I will probably lose money because I am treating each order in isolation. Everytime I sell to the buyer, the price goes up, making me lose money because my spread is too tight and I haven't identified the true intent of the buyer. Every time I sell, I am increasing my short exposure to the asset/derivative, so if the price moves up (against me), I am in a very real sense losing money.
If I can identify the meta order, I can shift my quotes up in order to compensate for the price impact all these small orders are going to have (remember, though they are individually small, they actually represent one big order).
So basically, market making is a game of predicting the short term future price of a security, and quoting buy/sell offers at appropriate levels. The less volatile and less toxic and more liquid a market is, the tighter I can quote. The more volatile and toxic a market is (and less liquid), the looser my spread must be. Remember that I'm not trying to make money on the directional moves of an asset (I'm trying to be "delta neutral"), but rather profit off of the bid-ask spread. My goal is to turn over inventory as quickly as possible (ideally buying and selling at the same exact time).
So if someone's buying a stock, the market maker actually takes a short position to make it available to the buyer? I was under the impression that market makers are just connecting market and limit orders with each other, is that not the case?
It's really complicated and I don't want to go into too much detail, but no, a market maker isn't "connecting" limit orders. A market maker is a market participant, just like me or you (well, sort of). They buy things and sell things, they don't have magical powers.
People get confused, but most hft firms utilize market making strategies. A market maker is just someone who puts limit orders on the book (making) vs taking liquidity off of the book (takeout). Anyone can be a market maker, and many firms do both market making and taking.
No, the exchange already matches a buy at market order to the best limit sell. A market maker is who is filling up the order books with offers to buy and sell at different prices under the hope that a regular trader will come in later with a trade the other direction at a better price.
So roughly, the idea is that if I’m smart money (say a big hedge fund or institutional trader), behind any of my trades is an implication that I know something worthwhile. So my trades will move the market, and this can leave market makers holding the bag if prices move quickly.
But if I‘m the proverbial dentist, my trades are just noise that don’t signal anything real about the market. I can get better execution because market makers aren’t worried about my trades moving the price out from under them.
Am I in the right neighborhood here?