Selecting Stocks for Market Making by Spread, Volume, and Hedging Risk
Summary
The document considers how a scalper or market maker with limited capacity should choose equities from a larger exchange universe. The proposed first-pass ranking uses expected spread revenue, represented by trading volume multiplied by bid–ask spread. The response argues that this measure already reflects some effects associated with market value, liquidity, competition, and volatility, since these characteristics influence volume or spreads.
A second response adds a portfolio and risk consideration: prefer stocks with more available hedges or less idiosyncratic risk. The discussion is a high-level heuristic, not a complete selection algorithm or empirical test. It does not specify how to estimate realized captured spread, account for adverse selection, inventory costs, fees, capital limits, or correlated positions. Thus spread times volume is a starting proxy for opportunity, while risk and hedging capacity may affect the final ranking.
Key ideas
- Rank candidate stocks initially by volume multiplied by bid–ask spread as a proxy for revenue opportunity.
- Higher volume and wider spreads can pull stock selection in different directions.
- Volatility can widen spreads but also increases the risk of holding inventory.
- Stocks with better hedging opportunities or less idiosyncratic risk may be preferable.
- The proposed ranking omits several costs and risks needed for a production decision.
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Full text
# Algorithm for the choice of stocks for a equity scalper/market maker to engage in? # Algorithm for the choice of stocks for a equity scalper/market maker to engage in? Assume a scalper/market maker who is operating on an exchange with $N$ stocks with different characteristics such as current market value, average bid-ask spread, average daily volume and historical volatility. Due to constraints imposed on this market maker he can only engage in $n$ of the $N$ stocks on the exchange, where $n << N$ ($n$ is much smaller than $N$). Thus the market maker needs to choose which $n$ stocks to engage in. Obviously he wants to choose those $n$ stocks so that he maximizes his risk reward ratio. What procedure/algorithm should the market maker follow to choose which stocks to make a market in? What trade-offs does he face in his choice? ## Answer by Ram Ahluwalia (score 6, accepted) https://quant.stackexchange.com/a/1193 All things being equal, stocks with the highest bid-ask spread present the greatest opportunity for the market maker The size of the opportunity (i.e. revenue expectation) can be represented as Volume * Bid-Ask Spread. Your algorithm should rank-order that revenue expectation Stocks with high current market values will tend to have narrower spreads and be more liquid (i.e. smaller bid-ask per transaction), more competition from other market makers, but also more volume. So there is a trade-off in volume vs. spread in current market value. However, all of this should be captured in the "Bid-Ask * Volume" formula anyway so I don't think that variable is necessary Historical volatility will tend to increase the bid-ask spread (i.e. increase the compensation to the market maker). The market-maker is compensated for providing liquidity and holding inventory in a dynamic market (Trade-off #2). Again, this would already be factored into the bid-ask spread so you can ignore this variable as well ## Answer by user508 (score 3) https://quant.stackexchange.com/a/1186 I don't know about an algorithm, but you probably want to pick the stocks that have the most ways to hedge, or the ones with the least idiosyncratic risk.
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