Market Making: An Integral Strategy at SDI Partners
What is market making?
In the financial landscape, one of the essential figures is the market maker, who practically keeps the market in motion.
Market makers buy and sell financial instruments such as equities, bonds, and foreign exchange on their own account in real time so that buyers and sellers of such instruments have constant access to liquidity.
The business of market making
We are what you call passive market makers, meaning our business model as a market maker is to profit from the bid-ask spread. SDI provides prices and sizes at which other market participants can buy and sell. By doing so, SDI will trade and profit if it completes both a buy and a selling trade.
In other words, as a market maker, we offer a ‘two-way quote’ to the market, indicating our readiness to both purchase and sell a security at competitive prices, regardless of market conditions. The profit will be from the ‘spread’ between the bid price (the amount a buyer is prepared to pay for a security) and the ask price (the amount a seller is willing to accept) that our algorithms have set. This difference is referred to as the bid-ask spread.
For example, if Apple stock was trading around $175 per share, we may offer a bid price (the price we are willing to buy) of $174.95 and an ask price (the price we are willing to sell) of $175.05. The $0.10 difference may not seem like much, but consider that 90 million shares of Apple trade hands every day. If we hypothetically handled every trade on a given day as the market maker, that would add up to a cool $9 million profit in our pockets.
In today’s highly competitive and efficient markets, the bid-ask spread is often much less than one percent of the price of a security. To generate revenue, we must accurately price securities almost instantaneously and execute trades at significant scale.
We also need to carefully manage our risk and anticipate how market dynamics might change over time, as after only completing the buy or sell side of a trade, the position could move against us, the market maker, resulting in a loss.
For that reason, our cutting-edge AI-powered algorithms aim to buy below a fair price and sell above that fair price, whatever that fair price may be. In this, a good fair price calculation/prediction is essential and is made possible through artificial intelligence and machine learning capabilities. The ability to predict the next mid-price (or an alternative measure for the price) allows the algorithm to modify its prices in time and be more likely to end up with a position that does not move against us. This allows us to keep our trading operations as risk neutral as possible while collecting the bid-ask spread that generates a lot of our profit.
We also employ a delta-neutral market-making strategy to earn consistent bid-ask spread profits without exposure to the directional risk. We do this by hedging our buy positions with a combination of options contracts with a negative delta. This involves selling put options or buying call options with a delta slightly less than +1.
Some benefits of market making
- Dependability: The involvement of market makers facilitates the efficient execution of trades, mitigates price volatility, and highlights discrepancies in supply and demand. These functions foster trust among market participants, as market makers contribute to the reliable operation of markets, ensuring their resilience even in periods of market instability.
- Liquidity: Market makers facilitate the rapid buying and selling of securities for investors, accommodating both quick transactions and large volumes. They play a crucial role in enhancing market liquidity and depth. During periods of market volatility, market makers are essential in providing liquidity and depth, particularly when other market participants may be absent, thereby contributing to the overall resilience of the markets.
By facilitating liquidity, we enable investors and traders to execute trades swiftly and at equitable prices, regardless of market conditions. This function, in turn, fosters confidence among market participants.
Values & Regulation
Market making is a highly regulated business, and as market makers, we operate within a framework of stringent regulations. We collaborate closely with regulatory bodies across all the markets in which we function and aim to contribute positively to the global market structure, enhancing investor confidence in the integrity of the markets and ensuring access to financial opportunities.
Visit sdi.partners to learn more about us.
