Market-Maker Quote Skew, Inventory Risk, and Order Priority
Summary
The document considers how a market maker with no initial inventory might submit orders to capture the bid-ask spread, and whether submitting both sides is preferable to sequential or one-sided strategies. One response explains that market makers generally quote both bid and ask prices, then skew those quotes toward a desired trade. They may quote only one side when limits or an end-of-day exit make additional exposure unacceptable; a maker seeking no exposure may withdraw both quotes.
A second response describes strategies one and two as equivalent when their limit prices are set equally and there is no risk-free return, while the strategy that submits both orders is slightly better under those assumptions. Its advantage is queue position: with price-time priority, the later order may sit closer to the market and have a higher chance of execution. The relative benefit depends on the instrument and can be negligible. The discussion is conceptual and does not model fees, adverse selection, or changing market conditions.
Key ideas
- Market makers commonly quote both sides and skew prices to reflect desired trades or inventory.
- A market maker may quote only one side when position limits or an impending exit constrain inventory.
- Under the stated equal-limit-price and no-risk-free-return assumptions, strategies one and two are equivalent, while the two-sided strategy has a slight advantage.
- Under FIFO priority, the advantage can come from a better queue position and a higher execution probability.
- The size of the queue benefit varies by instrument, and the discussion omits other trading costs and risks.
Tags
Full text
# Order submission strategies of a rational market maker? # Order submission strategies of a rational market maker? Consider a market maker that has decided to try to make a round-trip trade in stock A in order to capture the bid-ask spread. Assume furthermore that he has no current inventory in the stock A. To further simplify things assume that he wants to trade only one share in stock A. The market maker now has to choose in which order he should submit the orders needed to complete this round-trip trade: Does strategy III strictly dominate strategies I and II? Under what circumstances would a rational market maker want to use strategy I or II rather than strategy III? ## Answer by chrisaycock (score 11, accepted) https://quant.stackexchange.com/a/1230 Market makers place quotes on both sides (ie, the bid and the ask). Depending on the market, the MM might even be contractually obligated to provide liquidity within some threshold. NYSE's designated market makers (who replaced the specialists a few years back) are an example. Even when there is no explicit requirement, the MM will quote both sides and simply shift (or skew) the quotes in the direction of the desired trade. For example, say the MM is bullish on a stock whose midpoint is USD 50.25. The MM might bid 50.24 and ask 50.35. This of course glosses over issues like volatility or liquidity of the stock, both of which will cause the spreads to widen or tighten. The only time I can think of that an MM would quote only one side is if it can't possibly take-on more of an existing position, like in position limits or when trying to exit at the end of the day. An MM who doesn't want any exposure simply won't provide quotes on either side. ## Answer by lehalle (score 8) https://quant.stackexchange.com/a/3287 There is a paper of mine answering To this question: Dealing with the Inventory Risk. A solution to the market making problem by Olivier Guéant, Charles-Albert Lehalle, Joaquin Fernandez Tapia. ## Answer by Serg (score 5) https://quant.stackexchange.com/a/2548 Assuming that: - limit prices of Long and Short orders are equally pre-calculated in all 3 strategies; - there is no risk-free return; strategies 1 and 2 have equal quality, and strategy 3 is slightly better. However, the only advantage that strategy 3 takes over 1,and 2, is better location of the orders in the price level queue. In case of FIFO (price-time priority) matching algorithm, the second order will be closer to the market, and execute with higher probability. In some instruments this delta can negligible, in others - important.
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