Market-Maker Risk: Inventory, Adverse Selection, and Price Gaps

# Is price gaping the major risk that market maker has?


# Is price gaping the major risk that market maker has?












Suppose you are a market maker. So you put a limit price out and hope someone will cross bid/ask spread to take your limit. But there is risk that bad news could come out and market will gap. So your limit gets hit ( price goes right through your limit ) and you are stuck with immediately loss due to market gaping.

Is this the main worry of the market maker ?

## Answer by pteetor (score 11)

https://quant.stackexchange.com/a/9529

At the risk of stating the obvious: market gaps are a problem only when the market maker is holding a position and the market gaps against them. So the gap problem is really an instance of a more general problem: inventory management.

The market maker's goal is to profit from the bid-ask spread. They prefer to be flat, but at any given moment, they could be holding some inventory, waiting to unload it. The market can go against them at those times. It could move slowly or it could move quickly. But if the market makers cannot unload their inventory profitably, they'll lose everything they gained today ... or more. In a gap market, the probability of unloading inventory profitably falls dramatically.

In short, inventory management it critical for risk management.

My market maker friends say they are "picking up pennies in front of a steam roller." They make a little profit on each transaction; they get crushed when they're holding inventory and the market moves against them.

## Answer by smyoo (score 4)

https://quant.stackexchange.com/a/9530

A previous responder says "market gaps are a problem only when the market maker is holding a position and the market gaps against them." This is for sure a risk, but not the only risk.

There also can be a problem if you don't hold a position and the market gaps. Suppose you hold no position on Sept 11, 2001 but you have limit order to buy. You are waiting for someone to hit your bid. But then planes hit twin towers. Your bid is filled at limit. Market drops 1000 points right through your bid, filling you in process.

In bid situation you risk downside risk and no upside. In holding inventory you risk downside risk but can gain in upside swing. You cannot gain in upside swing if no inventory and waiting on bid - in this case market runs from you.

## Answer by Jon Grah (score 2)

https://quant.stackexchange.com/a/32541

The larger fear is always trading against a more informed player than yourself. `Informed``=``right knowledge``of market direction +``willingness``to act/react timely to capitalize on momentum.` This includes taking into account unexpected volatility of flash crashes, news announcements, etc.

In your example, yes, it is possible to already hold a position on your books OR be obligated to hold a position (resting limit order, minimum avg daily/monthly volume requirements, etc), and then get caught in a sharp price move, resulting in individual trade losses. But part of inventory management that @pteetor eludes to requires that you strategically hold losing positions until you can offset them at a net gain (see loss leadership). So it is common for market makers (stated or de-facto) to use some sort of cost averaging so that they spread the risk out over several trades. Maybe this screenshot will help illustrate:

In theory, it is unlikely that the market will go to "ZERO"; so the fundamental value must eventually revert. But remember SNB? It's the holding of the positions in between reversions that could be "scary" and requires proper risk management.

## Answer by confused (score 0)

https://quant.stackexchange.com/a/57023

Depends on what you are trading and your position. If long gamma, gaps are great because you didn't continuously hedge yourself. Those are the best moves a market maker can wish for. Being long options, go home, wake up the next day and the market is ways away from yesterday's close. You hedge, and go and grab some beers.