Hedging client positions

[gooseman]

holy sh1t GJ-are you bored?

 

[Skill Leverage]

That was the gayest post since Elton John and David Furnish spent Christmas in different countries

 

[TheBramble]

GJ – I imagine that is your own work, in which case, that has to be one of the finest, most concise and certainly most entertaining explanations of not only the Market Making process, but a little more besides as I’m sure some of us realise. If you’ve half-inched it, well done for posting it here anyway.

My hat off to you young man.

There’s a career for you in Retail if trading loses its lure….

 

[TheBramble]

That was the gayest post since Elton John and David Furnish spent Christmas in different countries

Only Gays know the names of famous Gays' boyfriends....

 

[GammaJammer]

Own work sadly mate - would rather have cut and pasted so I could get back to buying cr@p on Ebay. But I promised to post a serious explanation, and I just got a bit carried away.

And yes Goose - bit of a slow morning mate.

 

[Skill Leverage]

Having a subscription to Hello! magazine doesn't make you gay. Probably

 

[GammaJammer]

Only Gays know the names of famous Gays' boyfriends....

That's his boyfriend?

Oh dear Tony....

 

[gooseman]

not enjoying markets right now. it's rubbish.

 

[Skill Leverage]

yeah, it's actually his husband Bramble. Ya queer.

 

[TheBramble]

That's his boyfriend?

Oh dear Tony....

It was an assumption, an assumption I tell you!

 

[TheBramble]

yeah, it's actually his husband Bramble. Ya queer.

Are you Long Closet Futures...?

 

[Skill Leverage]

Nah I'm more interested in the spread

 

[Schopen]

In a nutshell Goose has it. He's not trying to be facaetious (sorry poor spelling). A Market makers job is to provide an orderly and tradeable market in an instrument, such that others may buy and sell, by providing liquidity to that market. Liquidity is the CAPACITY for someone to buy or sell.

Thus you could (verly loosely) think of a market maker as a shopkeeper. They have in their mind a fair value price for, say, a pack of batteries. They will speak to various people, some likely to be sellers (sales agents for the battery company, cash and carry wholesalers etc etc), some more likely to be buyers (usually customers to their shop). If the price of the batteries at fair value is £1.00 they might make a market effectively of say £0.80 / £1.20. That is, at any one time they'd be willing to buy them from the sales rep at £0.80 if he popped his head round the door, and they'd be willing to put em on the shelves with the little pricing gun reading £1.20.

Of course, if the batteries aren't exactly flying out the door at £1.20, and the shopkeeper has boxes and boxes of em out the back, he has a potential problem.

So he leaves his assistant in charge and steps outside into the sunlight. Stretching his legs, he has a little stroll down the high street. To his horror, he sees that the other small shopkeeper is selling the same batteries at £1.15. And the big out of town supermarket has even put an ad in the bus shelter saying they undercut that, knocking them out at £1.09.

So he reduces his offer to £1.12 for now. He's not trying to compete with the supermarket, he just wants to be the best price on the high street. And when the sales rep calls the net week he tells him that realistically he can only pay £0.75 now. The sales rep declines to sell him any there, but the good news is that the batteries are selling well at this new price, and pretty soon he's running low.

Taking a quick trip to the cash and carry he is shocked to see that the battery aisle is almost empty. People are literally carting away trolley loads of the things. He sees his mate who runs a shop nearby and asks him what's going on? His mate replies that there's been a strike at the battery factory, and also a huge fire at their distribution centre. So there are maybe two days worth of battery stocks left in the country.

Seeing a chance for a good outcome here, our guy also loads up his trolley. In fact he loads up with 5 trollies worth until the shelves are empty of the AA and AAA batteries he stocks. These are priced at a very reasonable £0.85 a pack

Then, when the sales rep for the battery fails to show the next two weeks running he knows he's onto a winner. Sure enough, the ad from the supermarket in the bus shelter is pulled, and the shop down the road now has the batteries at £1.18. So he lets a little of his stock go back on the shelves at £1.15 and they're gone within a day. SO he tries a little more at £1.15. Those don't last a morning. Now he's starting to sense a pattern. And when his mate from the other shop pops in and asks to buy a carton as he already sold out, he knows that he's doing well. He sells his mate a carton at £1.00, as he's grateful to his mate for the heads up that made him do the trade in the first place. But the rest of the batteries go out on the shelves at £1.25, £1.30 and eventually, once the story makes the papers regionally, he's still selling at £1.45.

Not only that, but as he seems to others to be a guy with his ear the ground and a steady supply of batteries when others haven't, he's now getting people asking to buy in bulk. He's less keen to do this at first, but then, one day, he reads a report in the local rag that says that the battery company have made great strides in repairing the regional distribution depot, and that the batteries should be available soon.

No-one else seems to have seen this yet. So when the owner of another, larger store asks him if he can sell him some batteries, he says 'sure - I can spare you a few. How many were you thinking of'. The larger shopkeeper tells him. It's a lot of batteries, more than he actually has left. So he hits on a plan.

"Sure, I can sell you some - after all we have to stick together in the face of the supermarkets right?" But I don't have everything now. So how about I sell you three pallets now, and the remaining 7 pallets for delivery tomorrow. And if you pay in advance, I'll sell them to you at, say, £1.30 rather than the £1.45 I have them on the shelves for now.

The larger shopkeeper happily agrees, thinking that he has a small edge on the trade. And for a day he does manage to sell some batteries at £1.45. But not as many as he'd hoped for.

The next day the small shopkeeper hears a tinkle and the door opens to reveal the sales rep again. He's very apologetic about the recent hiccups, but states that the stock is starting to roll in now. Unfortunately, it's still a bit scarce, but he can let the shopkeeper have 5 pallets for £1.10. It's a little more than the shopkeeper had been paying previously, but he does have an obligation to meet that day (to the larger shopkeeper) so he agrees.

He then goes round to the cash and carry place, as he's thinking they were possibly the sales rep's best / largest customer and therefore first call. Sure enough the shelves are, if not full, then certainly a lot less bare. So he buys another ten pallets, this time at £0.95. Happy days. He then delivers the 7 pallets to a somewhat sombre shopkeeper at the large convenience store who, having also been to the cash and carry that day, had not taken long to realise that he'd bought at the top of the market. Our little guy immediately slashes the batteries to £1.20 and sells into the last of the uninformed buying by hoarders to power their dvd remote controls etc, who had either not realised things were getting back to normal, or who simply needed the batteries now on account of the fact that they couldn't be arsed to get up off the sofa and waddle over to change the channel manually.

Sure enough, within a week things are basically back to normal. Fair value for the batteries is back at around £1 a pack. But the little shopkeeper, having juged supply and demand perfectly, and been nimble enough to do something about it, had profited handsomely from the move .

THAT is market making. Supply and demand. That's all it is folks.

Hope this helps.

GJ

Thanks, that is awesome and gets better each time I read it.

 

[Schopen]

Some assumptions from your posts:

The Shopkeeper doesn't really need any batteries on the shelf, just as long as they can get their hands on some when a customer walks in the store.

Likewise the shopkeeper will need cash available if a customer walks in with batteries wanting to sell - shopkeep will buy low off the customer and sell on higher.

The shopkeeper doesn't need to keep customers batteries in stock after buying off the customer for when the customer wants to eventually closes her position i.e., the shopkeeper is obligated to buy/sell by his/her duties as a MM, not obligated by being cpty to the customers original opening transaction...?

So if MMs keep instruments on their books this is because they want to. Either they can't clear them off at the right price or they have a view on the price - and this is where he/she'd hedge..?

I don't know if these assumptions are too simple or true across all asset classes, or whether short selling/stock lending will muddy the waters.

 

[GammaJammer]

Some assumptions from your posts:

The Shopkeeper doesn't really need any batteries on the shelf, just as long as they can get their hands on some when a customer walks in the store.

Likewise the shopkeeper will need cash available if a customer walks in with batteries wanting to sell - shopkeep will buy low off the customer and sell on higher.

The shopkeeper doesn't need to keep customers batteries in stock after buying off the customer for when the customer wants to eventually closes her position i.e., the shopkeeper is obligated to buy/sell by his/her duties as a MM, not obligated by being cpty to the customers original opening transaction...?

So if MMs keep instruments on their books this is because they want to. Either they can't clear them off at the right price or they have a view on the price - and this is where he/she'd hedge..?

I don't know if these assumptions are too simple or true across all asset classes, or whether short selling/stock lending will muddy the waters.

Well there are subtle variations based on the actual instruments themselves. Which, If I had all day, I could theoretically weave into this particular metaphor. But it was just so people could get the general picture.

In the simplest possible terms how much 'inventory' a market maker carries varies with both supply and demand factors, as well as with the particular characteristics of their own market.

So for example stock borrowing can be costly, whereas on average the equivalent process for an FX market maker is smoother and more efficient (one dollar bill is pretty much totally fungible for the next which helps).

All I was trying to do was give a worked case study type example bringing together the dynamics of supply, demand, liquidity, execution constraints and price direction forecasting, which are the pillars of market making in all instruments.

I deliberately left it a bit vague rather than making it, say, FX specific.

Glad it helped.

GJ

 

[aarius]

This is hopefully my last post. I swear to god that was 10 f*ckin pages of bs and gay jokes. and poor schopen, nobody really helped him. I'm an equity MM and for the love of god if you don't know what you're talking about, or are unable to interpret an uninformed question, just shut the f*ck up. for now on i'm sticking to trade2win. damn.