[AllanHoustonSt]

The industry as a whole provides net value to the market by via higher liquidity and tighter spreads.

The arms race is a necessity due to rising competition. HFTs cannibalize each other every year. People on the outside seem to think being in HFT inherently means you’re printing money but they don’t acknowledge how tough the business actually is. Many firms have either collapsed or have been bought out over the past decade.

Market makers specifically (who inherently have to operate in HFT time horizons) don't even compete with low-mid frequency hedge funds and props. They don't compete with retail investors. They strictly compete against other MMs to capture the spread.

[gas9S9zw3P9c]

Out of curiosity, why do MMs have to operate on HFT time horizons? Couldn't they operate on a somewhat lower frequencies by quoting wider? Sure, they won't see the same profits, but why is it impossible?

[pgwhalen]

It's interesting the way you connect quoting with wider with lower profits. In a vacuum, clearly the opposite is true. But you're leaving out the part that you only stand a chance to trade and therefore profit if you have the very best price, so you can't quote wider otherwise your competitors will get the trade. If your quote is a million dollars wide, you won't make a million dollars less frequently - you'll never make anything at all.

That's all true for the very strictest definition of a market maker, which is pretty much necessarily HFT (in list US equities). But there are other types of traders that are successful of course, because their edge comes from thinking about the market in a different way. In situations where finely-tuned, data-informed, low-latency algorithms do not have the confidence to give good prices (e.g. illiquid securities or during times of volatility), these traders might be more successful.

[gas9S9zw3P9c]

Oh yeah, when I said "lower profits" I didn't mean per roundtrip, but overall lower profits over a longer period of time due to fewer trades happening at wider quotes. HFT almost always quotes minimum spreads, so my question was why you couldn't be successful quoting larger spreads (not $1M, but let's say 2-10x the normal spread) while trying to be "smarter" as opposed to faster, since with wider spreads you'd already be in front of the order queue when the price moves, in front of the HFT trader who has to react to the movement to quote his tiny spread.

I'm trying to understand where the market maker = necessarily HFT comes from. After all, we had markets makers well before HFT too. I understand that MM can be particularly profitable when doing HFT, but why is HFT a necessity?

[pgwhalen]

Your intuition is good, I think it's the terminology/semantics that are causing you confusion. What you're describing is a valid way to make money as a trader, but most people don't call it market making. The wider you quote relative to other market participants, the more risk you take on - because your volume is lower, you have to hold on to your positions longer, exposing you to greater fluctuations in price. Market making is very much about not exposing yourself to this kind of risk.

In real terms, if you quote a penny wide market, there's a much greater change that you can both buy and sell in a short period of time to capture that penny. However, if you quote a 10c wide market (when everyone else is quoting a penny), you might buy shares at $10, but it might be a much longer time before anyone wants to buy them back from you at $10.10 - in fact it might be never, they could go straight to 0!

Again, quoting that 10c spread is perfectly valid, it just means that your edge begins to be less about capturing "flow" as much as it is about predicting the direction of the stock over a longer time horizon.

[gas9S9zw3P9c]

That's a good point and it makes sense, but couldn't you hedge the inventory risk?

[pgwhalen]

I'm not totally sure what you mean by "hedge the inventory risk." How would you accomplish that? You can reduce your position size but that's not hedging, it's just reducing your exposure in the first place. You could use options, but that 1) exposes you to other risks and 2) is prohibitively expensive given the cost to transact in that market is much higher.

The best way to keep risk low as a market maker is to keep inventory low, which means you need to get out of positions quickly, which means you need to have competitive prices to increase your chance of interacting with order flow.

[AllanHoustonSt]

Traders (be it hedge funds, props, retail, anyone) will only "take your action" if you price competitively. You'll never get your orders filled. The open bid and ask as per whatever the exchange quotes are really the only prices that matter when it comes to what actually gets executed.

Also even if you do quote wider, to effectively capture the spread, your buy on one side and your sell on the other side still have to basically occur simultaneously which is where the demand for latency comes in so you really can't escape it.

That said there are ways to still be profitable even if you know you're not the fastest gun in the west across the most exchanges. Without going into too many details you'd have to selectively choose where/what you trade. Which is not trivial at all of course.

[gas9S9zw3P9c]

Hm, maybe I'm fundamentally misunderstanding something. Let's just say the price is a random walk. It's not directly relevant to the argument, but for simplicity. An HFT MM will make money by continuously quoting ask/bid at the best price, i.e. a lot of trades, capturing a very small spread each time. Given that it's a random walk, buy and sell don't always occur simultaneously either, e.g. in a trending regime where the HFT MM may start pulling quotes due to risk checks and/or inventory/hedging concerns.

So if I am an MM that quotes a wider but gets fewer executions at larger time intervals, shouldn't I be able to also make profit? After all, my queue position is in front of the HFT MM because I put in orders earlier (since I am quoting wider), latency here is irrelevant.

Can you explain where my logic is faulty?

[AllanHoustonSt]

I guess I would say, it depends?

Existing profitable MMs aren't all equally fast. So the slower ones that trade on the same exchanges or even the same indices have to be profitably trading at a wider spread.

HFT isn't a concrete term so I guess technically there's no hard line to draw for how fast your roundtrip times have to be to be profitable. But if you are trading wide enough where you think latency isn't a factor, aren't you really just predicting where you think the book will go "far" ahead in the future? MM is inherently a reactionary business (with some effort put into anticipating the price moving against you in the very very short term).

[gas9S9zw3P9c]

> But if you are trading wide enough where you think latency isn't a factor, aren't you really just predicting where you think the book will go "far" ahead in the future

Yep, or rather, predicting where the market will not go to avoid the price moving against my quote. My impression was that HFT is all about being fast, as opposed to smart, since you can't make complex predictions on nanosecond scales. Complex models don't fit on an FPGA. So couldn't you get an edge by being just a little bit smarter with predictions but slower and quoting wider spreads? And just to be clear, I'm not talking about minutes here, but maybe milliseconds to seconds, which I think wouldn't be considered HFT today?

[AllanHoustonSt]

There is trading activity in the milliseconds-seconds horizon as well. I'm sure all the big HFT players participate plenty. These just wouldn't be considered MM strategies.

Your original question was why MMs have to operate at HFT horizons. MMs by definition are liquidity providers (which means high availability and high volume at competitive prices). In some cases (DMMs) they're legally obligated to do so at some well defined baseline. And in that specific context HFT speeds are required.

[JoshuaDavid]

> Let's just say the price is a random walk

This is where your logic is faulty. On the time scale of for example days, the price is definitely not a random walk. If stock XYZ has a price of $100 at 9:00 am, and you put in a buy order at $99.50 and a sell order at $100.50, there are a number of ways for it to go:

1. The price drops to $99, your buy at $99.50 triggers and you now are long (expect the price to rise), the price rises to $101, your sell at $100.50 triggers, you make $1.00 and are back to your original position.

2. The price rises to $101, your sell order at $100.50 triggers and you are now short, the price drops to $99.00, your buy order at $99.50 triggers, you make $1.00 and are back to your original position

3. The price drops to $99, your buy at $99.50 triggers and you now are long (expect the price to rise), the price continues to drop to $95, you now have a share of XYZ worth $95.00 which you are offering to sell at $100.50. Either you exit your position (and lose $4.50) or stay in the position (in which case you have $99.50 less available to invest than before. Whether or not the position makes sense to keep, you are now a long-term investor, not a market maker.)

4. Same as number 3 except that the price rises to $100.50, your sell goes and you are now short XYZ, the price continues to rise to $105.00 and again you either exit the position and lose money or don't exit and are long-term short XYZ (and never make the money back if the price never drops back down).

In order to make a profit, 1 and 2 have to happen 10x as often as 3 and 4 for the particular values mentioned above.

If you widen your spread, you will make more money each time the random walk of the market goes from one side of your spread to the other, but that will happen less often (whereas large one-way market moves that more-or-less permanently move the price to a level where it no longer crosses your spread stay roughly as probable as before).

If you narrow your spread, you will make money more often, but less each time. HFT firms are an extreme example of this - they have very (very!) narrow spreads that they trade on millions of times per second, pocketing a fraction of a penny each time (unless the market moves, in which case they lose money just like any other market maker, but events that happen every minute are "rare" when you are working on the timescale of microseconds).

There is a phrase, "picking up pennies in front of a steamroller", used in finance. The basic idea is that there are pennies (spreads) lying on the ground for you to pick up, but the steamroller (an actual movement of the market) could come along at any time and crush your profits.

[quickthrowman]

In short, someone else will quote a tighter spread and capture it.