Markus Kämpe at Orc Software discusses how market makers must leverage their skill in combination with new technology to remain competitive
Regardless of the current state of the financial markets or the appetite for risk, investors participating in derivatives have a need for liquidity providing facilitators. This type of market making activity has been seen in derivatives around the world since inception and the market making role has continuously evolved and been adapted to developments in listed derivatives trading.
Imagine standing in the pit 20 years ago – feeling the flow of the market; looking into the other traders’ eyes trying to read their mind on the next move to make; split second decisions to quote a market or spot a good deal and trade on it. Then go home at the end of the day having made thousands of trading related decisions solely based on your sense of the market and your head as number cruncher and risk tracker.
It is tempting to say that the core qualifications required to be a successful options market maker today are not far from what was needed 20 years ago – a developed sense for the market dynamics and an analytical mind looking for the next trading opportunity. The technology requirements for market makers today would then be seen as a natural consequence of global technology development since the early nineties.
Being a market maker today almost always means utilising and relying on technology. Market makers that manage to get enabled by (rather than forced to use) technology and fully exploit the capabilities of computerised trading are in a good position to succeed in today’s derivatives markets. It is important to remember, though, to never try to replace what can only be stored inside the trader’s mind with trading algorithms; technology is a key criterion to become a successful market maker, but it takes a lot more than just technology to excel.
The most obvious need for a market maker is to stream quotes to the market continuously. Since the competitive market maker uses tight spreads and significant volumes, it is imperative that the quotes in the market are immediately updated when the underlying future moves and reflect the market maker’s view on volatility at all times. It might sound like a simple task, but assume it should be done in the most competitive index options products in Europe and the challenge at hand is definitely not for the faint-hearted.
The competitive market maker needs to work the quotes in the market depending on market view, trades and changes in market conditions. As a market maker, the path to profitability seldom goes through few trades with major edge but rather many trades with smaller edge, adding up to a significant profit over a longer period of time.
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