As a market maker, your primary goal is to provide liquidity to the market by posting bid and ask prices for a given asset. By doing so, you facilitate trades and profit from the bid-ask spread. To set the bid and ask prices, you need to consider the following factors:
1. Mid-Market Price: The mid-market price (MMP) is the average of the best bid and best ask prices in the market. Ideally, bid and ask prices should be centered around the MMP to stay competitive.
MMP = (BestBid + BestAsk)/2
2. Inventory Risk: As a market maker, you maintain an inventory of the asset you are trading. If you accumulate a long (positive) inventory, you may want to set the bid price slightly higher than the MMP to reduce the risk of further inventory accumulation. Conversely, if your inventory becomes too short (negative) on a certain asset, you could set your ask price slightly lower to encourage buying and balance your position.
3. Trading Costs: Your trading costs include exchange fees, order cancellation fees, and any other costs associated with managing the trading system. You must take these costs into account when determining the bid and ask prices and the overall bid-ask spread to ensure profitability.
4. Market Volatility: In a volatile market, there is generally increased price uncertainty. As a result, market makers often widen the bid-ask spread to reduce their risks from adverse price movements.
5. Competition: It’s crucial to stay competitive with other market makers. Setting bid and ask prices too far from the MMP might result in fewer trades and a reduced market share.
After considering these factors, set the bid and ask prices:
$$(Bid~Price = MMP - \frac{1}{2} (Bid-Ask~Spread) )$$
$$(Ask~Price = MMP + \frac{1}{2} (Bid-Ask~Spread) )$$
Now let’s consider an example:
Assume the following market data for an asset:
- Best Bid: $100
- Best Ask: $101
- Market volatility: moderate
- Inventory risk: long position
- Trading costs: low
- Competition: moderate
1. Calculate MMP:
$MMP = \frac{100 + 101}{2} = 100.5$
2. Estimate the appropriate bid-ask spread based on trading costs, market volatility and competition. In this case, since the volatility is moderate, the costs are low, and the competition is also moderate, let’s assume a spread of $1:
(Bid − Ask Spread = 1)
3. Adjust the bid and ask prices for inventory risk. Since we have a long position, let’s increase the bid price by $0.25 and decrease the ask price by the same amount, to encourage more selling:
(AdjustedBidPrice = 100.5 − 0.5 + 0.25 = 100.25)
(AdjustedAskPrice = 100.5 + 0.5 − 0.25 = 100.75)
So, in this example, the bid price would be set at $100.25, and the ask price would be set at $100.75.
These calculations are simplistic and may need to be further refined for real-world applications, but they help demonstrate the key factors that market makers consider when setting bid and ask prices.