[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.