Editor’s Note: It’s pretty warm out here in Tahoe. I’m going to get on a boat...
Dear Fellow Traveler:
Did you ever trade baseball cards when you were younger?
There was always one kid who had elaborate trading schemes. He’d buy a card from one friend for $1 and immediately sell it to another friend for $2…
Congratulations.
You just understood market making.
We can end this article now…
Oh… but you want to understand market making on Wall Street?
That’s different.
This requires grown-ups in $3,000 suits doing the same types of deals with millions of shares per second.
All the while, they’ll tell us that they provide “market liquidity" instead of acting as “professional middlemen with really fast computers and guys living in Miami…"
Changing the world… one micro-transaction at a time…
Let’s dig in…
My favorite film about any financial crisis is Margin Call.
But if you find the time… be sure to see The Hummingbird Project.
If you want to really understand market making… not for the acting or suspense…
That 2018 film centers on two cousins trying to build a 1-millisecond faster fiber-optic cable between Kansas and New York to beat market makers on order flow… (because their therapy sessions didn’t work?)
Real heartwarming stuff.
The film explores the arms race for speed, portraying high-frequency trading (HFT) as a compulsively obsessed industry built on shaving milliseconds to outmaneuver everyone else.
That’s a little dramatic… but fair.
Market makers are the digital scalpers of Wall Street.
They stand between every buyer and seller, scraping pennies off each trade while claiming they're doing you a favor. Here’s how it goes…
When you want to buy Apple stock, you're not buying it from some other human who decided to sell at that exact moment.
You're buying it from a market maker who already owns a bunch of Apple shares and will sell them to you... for a tiny markup, of course.
When you sell… it’s the same process…
The market maker buys your shares... at a tiny discount.
Then, they pocket the difference. Volume is where they make money…
This is based on the "bid-ask spread," which sounds sophisticated…
In reality, it’s just a markup between wholesale and retail pricing that happens at every Seven-Eleven. Buy for a penny… sell for two…
Modern market making feels like a video game. But this high score is measured in microseconds… And the prize is someone else's money.
As I’ve said. HFT companies spend millions building data centers right next to stock exchanges. If they can shave 0.0001 seconds of transaction time, they can react to public order flow and market signals before slower competitors can respond.
They'll run fiber optic cables through mountains and under oceans for better trade executions.
Some firms have moved beyond fiber optic cables. Now, they’re using microwave towers because radio waves travel faster through air than light through glass.
Yeah, someone thought about all this… while I was busy playing Madden at 22…
When microseconds equal millions of dollars, physics becomes a competitive advantage. I studied journalism and economics. Whoops…
Market makers hire physics PhDs to build algorithms that can predict what stocks will do in the next 0.001 seconds.
Not next year. Not next month. The next thousandth of a second.
Algorithms scan news feeds, social media, weather patterns, satellite data, and the trading patterns of pension funds in Norway.
Anything that might move a stock price by a penny.
They're not trying to pick winners and losers.
They’re trying to be the guy running the vig during the Super Bowl. They make money while everyone else is gambling investing.
Of course, they're not illegally front-running your specific order.
That would be securities fraud. Instead, they've built sophisticated models that predict retail behavior patterns in aggregate. Because that makes sense…
It's like knowing that when certain news breaks, retail traders will panic-sell in predictable ways.
Technically legal, but it still feels like playing poker against someone who knows what card is coming next...
During the Flash Crash of 2010, the market collapsed 1,000 points in minutes, then recovered. Well, turns out the machines got confused and started selling to each other in an electronic panic.
In 2012, Knight Capital lost $440 million in 45 minutes when its trading software malfunctioned. They had a ton of high buys and low sells at the speed Eminem raps...
It turns out that when you let robots trade billions of dollars in microseconds, they occasionally experience digital nervous breakdowns.
Market-making used to be done by humans on trading floors.
There were hundreds of people competing with each other to take orders. Some did have significant technological advantages at the time…
However, it’s now dominated by just a few players, such as Citadel Securities and Virtu Financial. Citadel Securities handles about 40% of all U.S. retail stock trades.
So when you buy or sell stocks, there's a decent chance you're trading with the same few companies every time.
They've created a private tollbooth on the highway of markets… And Virtu (VIRT) stock tends to go crazy during periods of high volume and market frenzy.
What you might not know is whether your broker is getting paid by these market makers for sending them your orders.
That’s something called "payment for order flow…"
It's basically your broker selling your trade to the highest bidder.
Robinhood made this famous, but most brokers do it.
Technically, you might still get a good price, but it raises questions about whose interests are truly being served. More on that during another WTH is “that” letter…
Market makers do provide genuine value.
They make it easier to buy and sell stocks instantly.
But let's not pretend this is charity work.
They're running the world's most sophisticated arbitrage operation.
They bulldoze the market with math, technology, and speed to extract tiny profits from millions of trades per day. It's a pretty brilliant business…
Even if it feels like you're being charged a fee for using your own money.
Stay positive,
Garrett Baldwin
0 Response to "What the H- is Market Making? (Volume 10)"
Post a Comment