Market Makers, Spreads, and Short-Term Directional Trading
Summary
The document considers whether dedicated market makers are necessary for short-term directional trading. It frames market making as compensation for liquidity provision and asks whether informed directional traders gain when they trade against less informed flow. The answer emphasizes that market making can persist without exchange rebates: in that case, market makers may require a wider average spread to justify participating.
It also distinguishes dedicated market makers from other participants. Execution traders using limit orders can supply liquidity even when no one acts solely as a market maker, and a sufficiently effective short-term directional algorithm may trade against those orders under certain assumptions. The response offers no empirical evidence, strategy rules, or detailed account of those assumptions. It therefore gives a conceptual explanation of how liquidity supply and spread compensation can change, rather than showing that short-term directional strategies will be profitable in any particular market.
Key ideas
- Market makers may participate without exchange rebates if spreads compensate them for providing liquidity.
- The absence of rebates can be associated with wider spreads and different liquidity-provider economics.
- Execution traders’ limit orders can supply liquidity even without dedicated market-making firms.
- A directional algorithm may take advantage of limit-order flow, subject to assumptions not specified in detail.
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Full text
# Market-Maker existence impact to short-term informed directional trading # Market-Maker existence impact to short-term informed directional trading How existence of market-maker affects short-term directional trading? Normally when playing short-term directional we play against market marker that will cover losses from uninformed traders. But when market-makers are not commonly present at exchange? In my opinion its moving game to middle and long-term only, because of transaction costs. In other way, when market-making is zero-sum play that forces pay uninformed traders cost created by directional bets from informed traders, then short-term play will profit in general from uninformed traders costs. Based on that, it looks like its only moving profits from uninformed traders to informed that allow directional traders make more profit and trading at higher frequency. Did I missing something here? Did market market existence in general allow play short-term directional strategy? ## Answer by user2763361 (score 2, accepted) https://quant.stackexchange.com/a/11587 Market makers do exist when exchange don't pay rebates. The lack of rebates will cause the spread to be wider, enticing market makers to enter. There will just be a different "average spread" that represents the higher compensation requested by market makers to participate in a market without rebates. Even if there were no traders acting as pure/dedicated market makers, there would still be limit orders by execution traders which can be adversely selected for profit by a good short-term directional algorithm (under a few assumptions...). Unfortunately I didn't understand your last two paragraphs.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.