Market risk management
What can go wrong in a simple and graceful market maker strategy?
The answer is banal: an unforeseen market movement can not only leave it without profit, but also drive it into a loss. The opportunity to lose money due to changes in market prices is called market risk.
Imagine you are a market maker. You sold Rogam und Hoof AG 10 million euros at a rate of 1.0958 and are now waiting for the next client to sell you euros at 56 euros. ". Suddenly the news came in the news: The European Central Bank (ECB) is scaling back its quantitative easing program. While you are trying to figure out what it is, the market has already reacted: other banks are calling their clients quotes 86–88, a whopping 30 pips higher than before. After returning from lunch, the second client will never sell you euros for 56 euros. You will have to offer him a price of at least 86 so that he does not go to competitors. What`s the bottom line? You bought 10 million at 86 and sold at 58. Congratulations, you just lost $ 28,000. Try not to do this anymore.
How can a market maker protect himself from losses? The first and most obvious solution is to widen the spread between the buy and sell rates. If you offered the Rogues a spread of not 2 pips (56–58), but 62 pips (26–88), then even a 30 pip movement in the market rate would allow you to earn $ 1,000 by selling at 88 and buying at 87. Unfortunately for market makers, clients do not really like wide spreads and will happily go to competitors if their conditions are better.
The second option is to make your price more attractive to selling customers. If you just sold at 58, you might well be offering the next customer a quote of 56.5–58.5, even if the market mid rate is still 57. This is called a skewed quote. What`s the point? The purchase price of 56.5 has become more profitable, and if the client simultaneously communicates with a couple of market makers, then he is more likely to sell euros to you. You will get rid of the risk and earn $ 1,500. That`s less than $ 2,000 full spread, but not bad either. On the other hand, the selling price of 58.5 has become worse, and by doing this you want to scare away the client so that he in no case buys euros from you, increasing your risk.
Finally, like explained in forex trading strategy article, the third way is to “close” the position in the interbank market. Banks make prices not only for clients, but also for each other. You can call another market maker, get a quote from him with a narrower spread, say 56.0–57.5, and buy the 10 million euros you need at 57.5. This will lock in a profit of $ 500.
The attentive reader will notice that the quote 56.0–57.5 has been skewed to the left relative to the mid-rate of 57. Apparently, the second market maker recently bought a euro from his client and is now applying strategy number 2, that is, he is trying with all his might to spur you to a trade that will help him get out of the position. This way, two market makers can enter into a trade that will allow both of them to take profits.
By combining all three methods (spread management, incentivizing clients to reduce the risk of transactions, closing positions in the market), a market maker can more or less consistently earn his penny at an acceptable level of risk. This penny is not guaranteed, and each specific transaction can turn into a loss, but you can still make money over the long haul. It is enough to always keep in mind what the current position is, how much it can be increased, how much it will cost to close in the market, which clients are likely to contact in the near future, in which direction they usually trade, is it time to give skewed prices, what spread will be justified with the current volatility of the market, is it expected within 15 minutes of a press conference by the head of the ECB, is there a correlation between positions in the euro-dollar and euro-pound pairs, and a few other similar trifles.
If you are wondering if it is possible to transfer at least some of this work to a computer, then you are thinking in the right direction.