Market Makers

[00:00:00.07] - Speaker 1
In this lesson, we talk about the market makers and their activity, which is fundamental for the transparency of regulated markets. Market makers are financial companies or individuals who provide liquidity to markets by buying and selling large quantities of securities. They act as intermediaries between buyers and sellers and help facilitate trading by posting bid and ask prices for securities. Market makers facilitate trading by providing liquidity to ensure that there is always a counterparty available for traders to execute their orders. In the stock market, for example, market makers are responsible for providing quotes for stocks they are willing to buy and sell.

[00:00:35.16] - Speaker 1
They are required to maintain a certain level of cash and are often required to have certain amount of capital to support their trades. Market makers play a crucial role in the financial markets by providing liquidity and helping ensure there is always someone willing to buy or sell securities. They help reduce price volatility by providing a source of supply or demand when there are imbalances in the market. It is very important to understand how the market makers makes money. They do not profit from directionality of an asset's price.

[00:01:04.14] - Speaker 1
Market makers make money through the spread between the bid and ask price of a stock. This is called bid, ask, spread. When they buy a security, they do it at the purchase price and when they sell it, they do it at the sell price. The difference between these two prices is known as the spread and represents the market maker's profit. Their risks are associated with price movements and imbalances of their inventory of securities.

[00:01:27.26] - Speaker 1
To manage the risks, they engage in hedging strategies. Market makers may execute offsetting trades in the underlying securities or derivatives to neutralize their exposure to price changes. By effectively managing their risk, market makers can minimize losses and enhance profitability. During the course, we will discuss about the importance of delta hedging and how we can use this data to make more profitable trades. Market makers are a key element of the financial markets and their importance is higher in the option market where they play an important role in providing liquidity and helping ensure there is always a buyer and seller to every option contract.

[00:02:02.03] - Speaker 1
In the US the majority of option trade volumes are executed by market makers. There is a reason why market makers in the option market are especially important. Here we see a screenshot of the option chain of a stock. As an investor, we have thousands of stocks at our disposal. If we think of the US market, there are over 12,000 listed companies.

[00:02:21.03] - Speaker 1
For each stock, we have dozens of expirations and hundreds of strike prices. Without a market maker, it would be impossible for a buyer or seller to execute their orders. In this slide, we can see The Largest Market Makers first of all, Citadel, founded by Ken Griffin, is certainly one of the most important and profitable funds in recent years. In 2022, they reported $16 billion in earnings. This result made them the most profitable hedge fund or market maker in the world.

[00:02:48.13] - Speaker 1
Citadel became known to the retail world during and after Covid for the Robinhood saga and for several short squeezes from AMC to GameStop. We will also talk about this in the course and show you what happens during a short squeeze. Then there is Two Sigma, which has a portfolio of over 50 billion. Its market maker does market making for approximately 300 million shares per day in the US market. Hudson River Trading is a quantitative fund that does market making for approximately 5% of the U.S. market.

[00:03:16.28] - Speaker 1
All of these funds guarantee daily liquidity to the market. So they are good for the market, but they can also sometimes benefit from them. They handle large volumes and in some cases they can also see very quickly the volumes that will be executed. And in a very competitive financial world made up by computers, this can be a huge advantage. Now let's take a look at the ecosystem of the markets.

[00:03:38.17] - Speaker 1
We can divide the participants into four main capital markets. In this quadrant we find all those institutional entities that issue or receive capital. Let's take an example where corporations such as Tesla, Apple or Microsoft can enter the market to issue short or long term debt debt that can help them manage their day to day activities. Here we have institutions such as banks that provide capital and corporates that benefit from them. In exchange for interest, capital and commissions.

[00:04:06.10] - Speaker 1
We move to investment. Capital received or issue in the form of debt and equity is put to work to generate a return on capital. Companies get a return on equity, use financial leverage and invest in assets. For example, energy companies invest in drilling. Tech companies invest in new features to maintain their market share and so on.

[00:04:24.02] - Speaker 1
The retail world is also part of this section. Thanks to investment funds like ETFs, stocks and options, retail investors allocate capital by capitalizing in the long term. The active trader is also part of this quadrant. We can move to efficiency. And here is where we start talking about the market maker.

[00:04:41.12] - Speaker 1
Investing today is very simple. All you need is access to an online broker. But behind it is a very complex system. And getting the system up and running is very important. In 2008, the credit crunch following the fall of Lehman Brothers caused systemic risk because the bond market stalled.

[00:04:56.22] - Speaker 1
In that case, companies had difficulty issuing debt to finance working capital, which is necessary for carrying out daily operations and the economy. This brings us to the liquidity quadrant. Whenever we invest. Execution needs liquidity. When there is liquidity, it means that there are many buyers and sellers in the market.

[00:05:14.02] - Speaker 1
The market maker guarantees liquidity. For example, in March 2020, during the COVID crisis, we saw one of the worst crashes in history where participants sold assets to generate cash. All assets lost value, even those with inverse correlations. This happens because in times of uncertainty, participants are looking for more liquid and less risky assets. And for this reason, the market maker must step up and offer a market to whoever is selling to ensure the stability and efficiency of the markets.

[00:05:40.03] - Speaker 1
It is obvious that in highly illiquid times, the market maker asks for higher spread for their execution. But it is also important to understand that in these cases, the market maker is also taking a higher risk. Market making in March 2020, when everything collapsed, was certainly not easy. But this is their role in the market ecosystem. Now that we understand who the market maker is and the market ecosystem, we can follow an order from when we hit the buy button through the execution and settlement.

[00:06:05.23] - Speaker 1
For example, if we want to invest in Apple shares, once we have done our research and the number of shares we want to buy or sell, we can click on the Buy or sell buttons directly from our broker. The order is executed by platforms such as Robinhood Interactive Brokers E Trade almost instantly. But what happens after we generated an order? The broker sends the order immediately to a liquidity provider, an exchange, a market maker, or an ats. We have already talked about the exchange and the market maker.

[00:06:33.20] - Speaker 1
The third one is the ats. But what is an ats? ATS is the acronym for Alternative Trading System. An ATS is an electronic trading platform that is used to trade financial instruments outside regulated markets. ATS can be used to trade a variety of financial instruments such as stocks, bonds and derivatives and other products.

[00:06:51.12] - Speaker 1
ATS can be used by both large institutions and private investors and can offer greater flexibility and transparency than OTC market. However, ETFs also have risks such as lower liquidity and higher exposure to counterparty risk. In the last decade, ETFs have become increasingly important and this has made the markets run faster and faster. Now, in this slide, we see the main exchanges for trading derivatives and options. Now let's talk about the different types of order and execution that we can leverage to trade assets and derivatives.

[00:07:21.29] - Speaker 1
There are two feats for order execution. The first is market order. Market order is a type of order where traders can place buy or sell orders at the market price. Orders are then executed at the best price available at the time of order entry. The market order Feed provides better transparency where traders can see all orders entered and the prices at which they were executed.

[00:07:43.08] - Speaker 1
However, market order can also lead to risk as traders can suffer losses if the price moves quickly against them before the order is filled. In this case, we speak about the concept of slippage. The second type of order is the market by price or limit order. A limit order is a type of trading in which a trader can place buy or sell orders at a set price. For example, if a stock is traded at $100, we can place a limit order at 98 or 102.

[00:08:10.02] - Speaker 1
This allows us to execute orders at price levels without having to be in front of the monitor all day. This brings us to the question, where can I see all the orders that were executed? We have so far described the workflow or execution process, but as a retail investor, we have the ability to check all orders executed by participants during the day or historically. All transactions are in fact publicly available through the order book. The order book is a record of all orders of buy and sell of a given asset such as a stock or an option.

[00:08:39.22] - Speaker 1
You can find the order book in any trading or broker platform. The order book is used to show real time supply and demand for an asset as well as to buy and sell prices currently available on the trading platform. The order book is a very important tool for traders as it provides valuable information on the supply and demand of an asset. Additionally, the order book can be used to identify trading opportunities or monitor market movements. You can find the order book, also called time and sales, on all broker platforms.

[00:09:07.05] - Speaker 1
Here we see an example from Interactive Brokers TWS platform. On Tesla stock, we can see the time, price, quantities and the exchange where it was executed. Now we end this session by looking at the general positioning of market makers. As we will see in the next few lessons, each option strategy has its own payoff. Based on where we buy, the strike price, the time to expiry and moneyness.

[00:09:29.12] - Speaker 1
We can define a payoff or risk return of the option strategy. If the market maker gives you a price, he has the opposite payoff to yours. Generally speaking, we know that institutional funds tend to hedge against market crashes. A fund that manages a portfolio needs protection first and foremost. And this means that many of the positions we see in the markets are long puts.

[00:09:49.17] - Speaker 1
In some cases, to finance these puts, funds tend to sell options and go short calls in order to collect premium that reduces the cost of their hedge. The market maker is therefore short put and long call. We will talk about this in details, but when we talk about mentor Q models we will see how this positioning and the delta hedging activity of the market makers can help us better understand the market trend in the short term. This is a topic that could be talked for hours. If you want to explore in detail how the financial market work, you will find some links that we will leave at the end of the lesson.

[00:10:21.10] - Speaker 1
The material is very detailed and touches on all the topics we have covered in this section of the course.