What is Market Maker Strategy? And what are market making firms?
Market Making is as essential for crypto markets as it is for traditional stocks exchanges. Market makers act equally for buyers and sellers. Let us understand about Market Maker strategy and the role market making firms play.
What is Market Making?
Financial markets, crypto exchanges etc. use the services of specialists, known as market maker to ensure that the traders can make their transactions. A market maker holds equities or crypto in its inventory with the purpose of selling it to investors/traders. The fundamental role of market maker is to bring buyers and sellers together so trading can occur in an efficient and fair manner.
Market makers differ from brokers as the latter charge commission to find the right deals. Market makers purchase shares at bid price and sell at ask price. The difference bid-ask spread is the profit earned by them.
What are Market Making Firms?
Market making firms can be institutions, investment banks or brokerage houses that have large cash reserve to operate. Their responsibility is to keep the market active and balanced. Even in unpredictable and volatile times, these firms maintain significant trade volume, facilitating smooth trading activities.
You can term them as matchmaker. For example, you want 1000 crypto tokens at certain price. It is not necessary that a seller is available at the same time, ready to sell you 1000 crypto tokens at that same price. This is where these firms came it. they ensure that you get 1000 crypto assets from their own reserve at the ask price. Thus ensuring smooth business transaction and increase user activities.
Market Maker Strategy
The market maker strategy lies in the process they adopt and proceed with towards converting an illiquid market into a liquid one. High liquidity means traders can buy or sell a crypto asset without causing large changes in the market price.
Market makers do not have an opinion on whether the price of the product should go up or down. They make money on the difference between the bid-ask spread. When a market-maker trades on either side of the spread, they take a position in the market which is a risk. They will try and find a way to offset that risk by, for example, hedging that position with a different product. This is the role of a market making firm. To offset risks, firms utilise market maker strategy.
Strategy 1 – Delta Neutral
Delta neutral is a market making strategy utilizing multiple positions with balancing positive and negative deltas so that the overall delta of the assets in question totals zero. It evens out the response to the market movements so that the net change of position is near zero.
A simple example is that if you buy stocks of $100 and the underlying delta is 1. Therefore, your current position is delta positive of 200. Now you have to buy stock that has delta of -1 or -0.5. Buying it would help you in achieving a delta neutral position.
Strategy 2 – HFT Trading
In this strategy, market makers place buy and sell orders on both sides of the book, joining the spread (offering the best prices to buy & sell on the whole exchange), which means that they will be filled whenever someone comes along with a market order. This is effectively copying what other market makers are doing.
Sometimes the orders are skewed for example when market crashes, sell orders are more than buy orders. Then this strategy loses money. Many market makers chose to accumulate inventory if they have an insight (for example, if a market is trending, they might set higher sell prices).
Strategy 3 – Grid Trading
In this strategy, price range is used and limit orders are placed in increasing order throughout the book. The price is around the moving average of price. The strategy is that the price will move upward throughout the day, earning the spreads between buys and sells. The whole strategy depends on calculating the average price.
This is done by using price range. The price is calculated through moving average, moving average and a jump function or the current best bid-offer price reset periodically.
The Bottom Line
If you want to enhance liquidity for your crypto asset or decentralised exchange, you need the services of specialist market making firm. The firm would help establish your token and attract investors by providing an efficient and fair market.
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