How do market makers make money?

Market makers are the counterparty to your trade. They are why you can buy/sell anytime you feel like. Market makers need to make money too.

I will be writing about retail Forex market makers. Retail Forex has no exchanges, i.e. there is no single order book where the traders are required to place their orders. Instead, retail forex orders are fulfilled using a variety of means. Everything that ranges from bucket shops to CFDs to money changers to actual EOD transfer of currency is used to fulfill your trade. Your trade may not be fulfilled by your broker and other clients of the broker. Instead, your trade may get taken to a liquidity pool or a pool of liquidity pools where it is matched with other orders from other brokers. But somebody still has to be a counterparty. i.e. there are entities who are always available to be your (often times only) counterparty, no matter what the market conditions are. They are the market makers. (Contrary to popular belief, market makers exist even on ECNs).

People believe market makers to be this weird magical entity who by the sheer power of deep pockets and mathematics can always stay in the market even if the world is ending.

While it is true there is a lot of math behind the optimal way to make a market involving detailed studies of market microstructure and likes, the basic philosophy behind market making is to “make money”. Market makers typically make money in three ways:

  1. Commissions: Market makers charge a fee for creating liquidity e.g. they charge say 3.5 USD per 100,000 base currency traded.
  2. Spread: Market makers buy and sell the currency at different rates at the same time. This is what money changers and retail bankers do.
  3. Actual trading as described below.

All market makers while creating liquidity also seek liquidity from you and me. All market makers set up shop i.e. set the bid/offer prices at price points where there are more trades happening.

However, market makers cannot afford to forever buy from us when everyone is selling. They will go bankrupt if they try this. As soon as the majority of the traders start selling, the market makers move to their bid/offer prices to our collective stop loss levels where we are willing to buy back from the market makers at a loss.

Why do market makers seek the majority trader’s stop-loss regions instead of majority trader’s take-profit prices? Do they hate us? Isn’t that unfair? Answer: Market makers seek the majority’s stop-losses and set up bid/offer prices there because stop-losses are closer to order-opens than take profits. In fact, market makers do not know/care if an order is a stop loss or a take profit. They simply move to price regions where there is liquidity and make sure they don’t go knee deep into any position in their inventory. They try to keep their inventory position-neutral over long periods of time.

What happens when there is new information in the market, and when the majority of the traders are right, and the market makers do not have enough time to move their bid-offer gap to the price reflected by the new information? Don’t market makers lose money here? Answer: This is where the money made from commissions and spread come into play to help. Income from commissions and spread help market makers offset such losses. Market makers also do not offer infinite liquidity at the current bid-offer gap. In fact, the liquidity offered at the current bid-offer gap is very thin, and the gap moves as soon as an idiot/informed trader tries to act. When new information creeps into the market, losses from sudden trading pressure can be offset by moving the bid-offer gap and using the earnings from commissions and spreads.

How to beat the market maker? Answer: You can’t. Their roles are structured in such a way that they cannot lose. They will either make money off of you or if you are too good, they will make money off of other sheep in the market. You can only make money off other traders, not a good market maker. You would be better off thinking of them as a service/utility that provides liquidity when you need it.

How to beat other traders? Answer: You have to stay away from placing your stop losses in price regions where everyone places their stop-losses. That is where market-makers go to make their inventory position neutral. But that doesn’t mean you have to keep your stop-losses further away from your order-open prices. If you do that the expected value of your trade goes down, and the risk of ruin becomes an eventual certainty. Ideally, you should enter the market when everyone is stop-losing after there is new information in the market, so by the time they are all stop lossed and the bid-offer moves to the new price that reflects new information, you would have made money.

Be careful, though, if you get too good at making money and your broker lets the market maker follow your trades, your trades will be factored in as a new information in the market that affects the bid-offer price.

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