How Market Makers Help Traders Pay Less
Some traders are under the incorrect belief that Market Makers are the "devil" and out to get them when in reality, a Market Maker is simply a liquidity provider. They are there to ensure that trades can be easily entered and exited. They are not hunting stops or trying to move the market all over to make a trader lose. In fact, they prefer the market to go nowhere and just stay flat with orders flying in. As a Market Maker desires to be delta neutral, they want to buy at the bid and sell at the offer.
Ideally, a Market Maker will ensure there is liquidity until there is sufficient trader volume. Otherwise, it becomes difficult to exit trades that have already been entered.
Market Makers will go to where liquidity is. They want to buy at the bid and sell at the offer. They want to make the bid/ask spread. They do not want to be directional. When exposed directionally, due to insufficient traders on that exchange, they need to be able to exit, i.e. sell at the offer the contract they bought at the bid. They are looking at their total Delta risk on the trades.
This is part of where bid/ask spread (actually the main part) comes from as it is their risk management for being able to pass off the trade due to the lack of Delta neutrality during a lack of liquidity. The less confident they are they can pass off the risk immediately, the wider the bid/ask spread is. They need to build in additional profit, in case they end up losing their Delta neutrality temporarily.
Competition between traders and Market Makers on the same exchange will benefit a trader more than spreading traders and liquidity providers between multiple exchanges. This is a fundamental rule of how markets work, specifically Market Makers. What happens is the Market Makers basically stumble over each other to get that bid/offer filled so they can unload their risk. This, in essence, brings the bid/offer spread closer and closer.
How markets work with Market Makers on an exchange to drive down bid/ask spread
Bid is 44 ask is 49
Market Maker A got filled at a bid of 44 (A trader sold it and he bought it from them.) Market Maker A is now Long the contract and has delta exposure if the market falls.
Market Maker A and Market Maker B both have a quote of 49 on the offer (for them to sell it to a buyer).
Market Maker A does not want to be Delta long. They want to make bid/ask spread. They don't want Market Maker B to get the fill at 49, as they need to get the fill so they can sell off the contract they just bought and make the bid/ask spread.
By them then placing a bid to sell (to a buyer) at 48, it becomes the offer of 48 - the top quote is the best quote.
So now, the first level quote is 48 with Market Maker A. The second level quote is 49 with Market Maker B. By "tripping over" or stepping in front of the price, they help to ensure they are the one that gets the fill should a trader take the other side. They have some bid/ask spread to give them a little leeway should the market fall before this happens.
Now, if Market Maker B also needs to unload contracts, he may come in and bid to sell to a buyer at the offer of 47, which tightens the spread up even more.
Add in another Market Maker and it further tightens the bid/ask spreads. The more traders on the exchange, the more orders being filled, the more they want to hedge off that trade and the smaller the bid/ask spread becomes.
As you can see in this screenshot, the Market Maker who is offering 20 contracts has a bid/offer spread of $15:
However, another Market Maker comes in and offers a tighter bid at $25, bringing the bid/offer spread down to $12.50, thus increasing the bid $2.50 on the bid side ($25).
The 100 contract size Market Maker is also offering a better offer at $34 making the bid/offer spread $9 or 30 percent tighter.
Add in another trader putting an offer up at $25.50 and you can see the bid/offer spread comes down to a mere $0.50 versus $15.
This adds up to massive savings for the trader!
Nadex has recently added two new Market Makers to their exchange. Now with three Market Makers on board, the size has increased across the markets and the bid/offer spread has decreased as well. What was once only one Market Maker at 20 contracts, is now another Market Maker at 100, with other traders also participating in the tightening of the bid/offer spread.
Read more: http://www.benzinga.com/markets/binary-options/14/05/4523456/nadex-adds-two-new-market-makers-to-its-growing-exchnage-liquid#ixzz30ctVahuv
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