Market Making Concepts
Understanding how market makers work and how to trade against them
Learning Objectives
Market Maker Business Model
How market makers profit from providing liquidity
Core Function
Market makers provide continuous two-sided quotes (bid and ask) to facilitate trading, profiting from the bid-ask spread while managing inventory risk.
Revenue Sources:
- • Bid-ask spread capture
- • Payment for order flow (PFOF)
- • Rebates from exchanges
- • Proprietary trading profits
Risk Management
Market makers must constantly hedge their inventory to remain delta neutral:
Technology Advantages
Speed
Microsecond response times, co-located servers
Information
Real-time order flow, advanced analytics
Order Flow Dynamics
How market makers analyze and respond to order flow
Informed vs Uninformed Flow
Informed Flow
- • Large institutional orders
- • Unusual options activity
- • High-frequency arbitrage
- • Earnings/event-driven trades
Uninformed Flow
- • Retail investor trades
- • Random portfolio rebalancing
- • Hedging activities
- • Market-wide ETF flows
Flow Toxicity
Market makers adjust spreads based on perceived "toxicity" of order flow:
High Toxicity Indicators:
- • Large size relative to typical volume
- • Aggressive market orders
- • Correlated activity across multiple names
- • Pre-earnings or pre-announcement timing
Payment for Order Flow (PFOF)
Market makers pay brokers for retail order flow because it's typically less informed and more profitable:
Market Maker Advantages
Structural advantages that benefit market makers
Information Advantages
Structural Benefits
- • Lower commission rates and fees
- • Access to exchange rebate programs
- • Priority order handling
- • Risk management tools and credit lines
- • Tax advantages through market maker status
Gamma Scalping Advantages
Market makers excel at gamma scalping due to:
Retail Trader Counter-Strategies
How to trade effectively in a market maker dominated environment
Order Type Optimization
Favorable Practices
- • Use limit orders when possible
- • Split large orders into smaller sizes
- • Time orders during high volume periods
- • Use mid-point orders when available
Avoid
- • Market orders in low liquidity
- • Large orders near close
- • Trading during news events
- • Predictable timing patterns
Spread Analysis
Understanding when spreads indicate market maker positioning:
Timing Considerations
Optimal Trading Times:
- • First 30 minutes: High volume, tight spreads
- • Mid-day: Avoid unless necessary (wider spreads)
- • Last 30 minutes: High volume, but pin risk near expiration
- • Avoid major news releases and earnings
Strategy Selection
Choose strategies that work with, not against, market maker dynamics:
Pin Risk and Expiration Effects
How market makers influence stock prices near expiration
Pin Risk Explained
Tendency for stocks to close near major option strike prices on expiration due to market maker hedging.
Mechanism:
- • Large gamma at ATM strikes creates hedging pressure
- • Market makers buy/sell stock to remain delta neutral
- • This activity can "pin" stock price to strike
- • Effect strongest on high-volume expiration days
Max Pain Theory
Theory that stocks gravitate toward the price where maximum option value expires worthless.
Considerations:
While max pain provides interesting data points, it's not a reliable trading strategy. Market forces are complex and other factors often dominate.
Gamma Explosion
On expiration day, gamma can become extremely large near ATM strikes, causing violent price swings as market makers adjust hedges.
Key Takeaways
• Market makers have significant structural advantages but also provide valuable liquidity
• Understanding their business model helps explain option pricing and market dynamics
• Retail traders can compete by choosing appropriate strategies and execution methods
• Focus on longer-term strategies where speed advantages matter less
• Use market maker competition to your advantage in liquid markets
• Be aware of expiration effects and plan accordingly