Market Making for Beginners

The article “Market Making for Beginners” first appeared on Robot Wealth blog.

I’ve noticed that beginners are often attracted to market making. To the uninitiated, it sounds like easy money and constant action.

The reality, of course, is that market making isn’t the goldmine many think it is, especially not for beginners.

In this article, I’ll explore why.

Back in the early days of crypto, you could’ve made a decent living by simply quoting prices on various exchanges about 5% around whatever BitMEX was showing.

While those days are gone, there are still opportunities if you’re creative, persistent, and willing to embrace the fractured nature of the crypto market.

But ask yourself: do you really want to turn market-making into a full-time job? Because it quickly becomes one.

Let’s break down the basic idea of market making:

Market makers provide liquidity. They’re the folks willing to buy when you want to sell, and sell when you want to buy. In return for this service, they pocket half the spread (the difference between the bid and ask prices) on each trade.

Sounds simple, right? Well, here’s where it gets tricky:

1. You need to know the “fair value” of what you’re trading.
2. You can’t be wrong by more than half your spread on average.
3. Learning from your mistakes is expensive.

Let’s say you think an asset is worth $100. You might offer to sell at $102 and buy at $98. In a perfect world, you’d make $2 on every trade.

What happens if you’re wrong about that $100 fair value estimate?

Let’s say it should really be $95. Suddenly, everyone’s selling to you at your bid of $98.

That means that you’re buying above fair value, bleeding money with every trade.

“But wait,” you might say, “I’ll just adjust my prices!”

Sure, you can, and you should.

But remember, every adjustment based on market feedback comes at a cost. And when your best-case scenario is only half the spread, you can’t afford many mistakes.

This is the market maker’s dilemma: most of the time, you need to be right, or at least not wrong, by more than half your spread.

It’s a constant high-wire act with no safety net.

So, how do successful market makers do it?

They have better models for estimating fair value (and they update their estimates faster than others can pick off their stale quotes).

There are many ways to model fair value.

Often, this means looking at prices on other exchanges. If you’re making markets for Bitcoin on a smaller exchange, knowing the price on Binance would be a very good idea.

This isn’t unique to market making. Trading is largely about knowing which prices are good and which are bad, on average.

But market making differs from most other trading approaches in one crucial aspect.

In other forms of trading, you only get involved when there’s an obvious edge.

On the other hand, as a market maker, you’re always involved – you’re constantly quoting around your fair value. You can’t sit back and wait for the best opportunities.

Now, I’m not saying that you can’t make it work as a market maker.

But I very strongly think that beginners should focus on easier games.

Things like risk premia harvesting and crypto perpetual futures basis arbitrage require little execution skill and provide a path for building skills, experience and capital.

If you’re really interested in market making, a good approach to learning the ropes is to try to come up with ways to pick off bad quotes – act when market makers fail to update their notion of fair value fast enough.

That is, flip things around and be the person who takes advantage of bad market making.

You’ll learn a ton about market making without taking on the constant risk exposure by having quotes always dangling in the market.

We used to do this on DeFi.

We would create our own model of fair value based primarily on prices on centralised exchanges (and sometimes a premium or discount depending on the platform) and then pick off stale quotes on decentralised exchanges that were slow to update.

When we started doing this, it was surprisingly easy. You could make money by eyeballing two order books and click trading.

As we went along, it became increasingly competitive. To stay ahead of the game, we automated our strategy and optimised it as best we could.

Eventually, we could no longer compete, but it sure was a good ride.

I suspect opportunities like this still exist, especially in the murkier areas of crypto. Of course, they come with their own set of risks and trade-offs.

In summary, market making tends to be harder than most beginners think.

There isn’t a great deal of room for error, especially when your primary form of feedback costs you an asymmetrical amount of money compared to your edge.

As a beginner, start simple.

Focus on easier, more forgiving strategies first. Build your skills, your experience, and your capital.

Consider doing the opposite of market making as you learn the ropes – taking advantage of bad market making by picking off stale quotes. Then, if you still feel called to try market making, you’ll be much better equipped to take it on.

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