Exploring Market Making: A Comprehensive Example for Traders
Market making is the task of making markets for clients willing to buy or sell financial assets. This is performed by professional traders by taking the other side of clients in order to generate trading commissions. However, to generate business, professional traders must often offer better prices to clients than the market, incurring financial losses. The professional trader’s task is then to use the investment bank’s balance sheet to make back more than the money lost in making markets for clients. This is also called proprietary trading.
Market making is split into two roles the agency role and the trading role. The agency role involves the execution of trading orders for clients which are hedge funds and pension funds to earn a commission typically 5 basis points or 0.05% on each transaction.
Market making example: Buy $1,000,000 worth of Microsoft stocks at $187 per share. The investment bank earns a commission of $1,000,000 x 0.005 = $5,000
However, while executing the order, the trader is now “short” $1,000,000 worth of Microsoft stocks at $187 and must buy them back in the market to net his exposure.
If for example a client is willing to buy $1 million of Microsoft stock at $187 and the current price of Microsoft is $187.5, the trader will have to offer $187 to the client incurring an immediate financial loss on paper of $5,300.
The profit or loss for the market maker is the total sum of the commission earnt and the money made or lost on the trade when closing the position. The trader’s second role as a prop trader is to use the bank’s balance sheet to trade the markets and gain back the potential financial losses incurred by market making.