To round out the trilogy, I figured I'd write a third and final thread with some more qualitative insights and thoughts on market making and profitable liquidity provision
No math this time, but lots of important concepts to understand in practice
I'll frame things first by discussing limitations of the model from my last thread ("A&S")
There are several: (1) "Optimal" pricing might be too wide to get fills (2) It assumes prices are stochastic (random) (3) Inventory control is reactive, not predictive
Dec 5, 2021 • 36 tweets • 6 min read
My last thread on market making concluded that managing inventory risk is key to staying in the MM business
This one’s dives into exactly what that means, and I’ll walk through a cheeky math model for how to do it as a full automated / algorithmic trader
A few preliminaries
you should know market structure & terminology basics if you don’t already (e.g. order types, LOBs, spreads), this is a good intro, machow.ski/posts/2021-07-…
you should read the original thread first, this one is more advanced,
thought I'd kick things off by dropping some knowledge on electronic market making
a thread on how institutions are built by programming computers to buy low sell high
absolute basics:
market makers ("MMs") provide liquidity to a market by posting orders on the LOB
they buy slightly below the market price and sell slightly above it, i.e. if mid is $100 they post bids at $99, asks at $101, and make $2q per round trip (q = quantity traded)
