Back in the day, market makers were key cogs in most financial markets whether those markets were traded on open outcry floors (pits) or via phones. Being the traders who made prices and essentially the wholesaler at the centre of the market meant that market makers had to be the most skilled operatives in their market. They had to be the first to detect a change in sentiment, otherwise they would be picked off. Market making was also always a competitive environment.
This was the environment that I learned to trade in.
When trading floors ceased, order matching through computer based platforms took over from market makers in many markets and market making skills began to be lost.
HFTs
In some markets High Frequency Traders (HFTs) saw an opportunity to fill the void and many did very well for a while. However, in recent times the number and performance of HFTs has generally diminished.
Buying Order Flow
Some large firms and hedge funds also saw the potential from the absence of market makers by buying order flow from brokers and effectively becoming market makers. But interestingly, they tend to focus on buying one particular type of order flow; that of retail traders. (Back in my day I could only trade against other professionals!)
Large institutional and hedge fund type orders often have to be executed via platforms and investment banks tend to employ execution traders rather than price making traders. (Note how bank traders of today are NOT like bank traders of yesteryear- typically they no longer take risk today or take minimal risk)
Void filled with Misinformation
The absence of market makers has led to much of their skills and knowledge being lost and the void has been filled with misinformation. Let’s look at a few of them.
Market making style became unprofitable when pit trading closed
There is a lot of misinformation about the transition of floor traders to screens. As someone who was there at the time and was part of that process I can speak about that time from experience. I will only touch upon a couple of the major issues here but I have made a more in depth video on this topic for nordenmethod.com students.
It is true that many floor traders failed to transition to screen trading in the early 2000s but the context must be understood. Firstly, many of those who struggled were NOT ‘locals’1 on the floor, they were execution traders for banks and brokers. Having lost their jobs when the pits closed they decided to try trading for themselves; many for the first time.
Secondly, the original trading platforms were nothing like the ones we have today. So it was much harder to quickly access all the information that a market maker would require.
Thirdly, some adjustments were needed for screen trading and of course, not all traders were able to understand and make these. Those who could though, continued to trade profitably.
Even banks couldn’t make money
Some have argued that banks pulled out of market making because it wasn’t a profitable business; therefore it is claimed that the market making style of trading is no longer profitable. They also point to the demise of so many HFTs as further proof.
This is not true.
Many banks pulled out of market making due to financial regulation changes that required market making firms to set aside significantly more capital.
Additionally by the 2010s in my experience, many of the HFTs and the few market makers who were left, no longer had the same skill set as their predecessors. In fact I saw this first hand as I consulted to some of these firms. Many of these traders had the same misconceptions about market making as the general trading public.
Market makers front run orders
One of the biggest misconceptions about market making is that they mostly front run orders. By this what I mean is that market makers look to identify large orders and then jump in front of them.
This is a very simplistic and incomplete description of market making. However, I would suggest that many HFTs were indeed built on this premise which is one reason why in my opinion, many did not last long.
There is far more to the market making style than just front running large orders.
Know when to fill them
Ponder this question, “Does Citadel buy the order flow from Robinhood so they can front run retail traders?”
Put another way, “Why would a professional trader front run an amateur?”
The answer to the first question is of course, ‘No’ and the second ‘Typically they wouldn’t’.
Sure there are times when a front running style is the preferred trade but the real skill of market making is knowing when to fill an order. This is the area where many HFTs are deficient. In a professional/institutional context, a true market maker should be able to fill a large order (take the other side to them) not just jump in front of them. This is definitely a skill which is being lost.
Indeed, a market maker should also be happy to fill a large institutional order from a trader who is trading on a different time-frame.
Firms like Citadel are happy to fill retail orders which is why their model is more sustainable than most HFTs. Of course, unlike my time as a market maker where I had to trade against large hedge funds and rival investment banks, Citadel et al know they are trading against the weakest traders in the market. They are effectively acting as the ‘House’ (casino) in the gambling industry and as we all know, that kind of edge is usually ongoing.
Requires key skills
Being able to fill orders requires some key skills and more in depth knowledge of market dynamics and participants. There are some in-built forms of edge that can help us achieve this but they must be properly used and understood. A deeper understanding of the difference between price and value is also required.
Typically these skills are not in the retail trading domain and perhaps we should not expect them to be. Certainly most retail trading educators do not come from a market making background and therefore cannot be expected to know or teach them.
Can only be applied to certain products
If you want to apply a market making style of trading then ideally, you need to choose a market that doesn’t already have market makers or orders routed through them. Therefore, many equity markets, options markets, CFDs and FX platforms cannot be used.
Futures markets remain arguably the fairest and most transparent product to trade, particularly for those using a market making style. They enable us to trade directly against other retail traders.
Can retail traders trade in this way?
I am often asked if this style of trading is suitable for retail traders. The answer is yes and no.
While the skills and techniques can be learned and applied by retail traders (it isn’t rocket science) they do require significant investment in time and effort and the ability to operate at a focus and intensity that many retail traders will find uncomfortable. It is a professional style of trading that requires a professional mindset. Think about the difference in intensity and focus between a recreational sports person (for example golfer) and a professional.
You need to be happy to perform the role of bookmaker rather than punter which while being a less glamorous style (you can’t brag about great calls and predictions) is usually more sustainable. It is very much a grinding style and the lack of quick riches will put many retail traders off.
However, if acquired, I strongly believe that the skills and knowledge of a market maker (or market making style) are among the most valuable skills a trader can have. Indeed, as many of the skills are being lost, one could argue that those who have them have more edge than they had say, ten years ago.
Podcast Interview
I was recently interviewed by Aaron Korbs for his podcast which is available on the major podcast apps as well as on YouTube here. I really enjoyed this one and feedback so far has been very positive. I hope you enjoy it!
Keep Grinding
Gary
