“Market making” is essential in financial exchanges, yet the term has become almost mystical in crypto. In this “Long Story Short”, we’ll show you that this trading strategy is not as out-of-reach as it sounds.
What is market making? In its simplest form, it is a strategy in which a trader places passive buy and sell orders, and moves them in a manner they anticipate might make them a profit over time. Similarly to any other trader, a market maker hopes to buy at a lower price than they sell on average. Whenever a market maker places an order, they need to decide at which price to place it, but how do they determine this? There are a lot of factors, but let’s focus on these: (1) reference price, (2) offset, and (3) lean (see image).
At the centre of their pricing calculations, the maker uses a reference price in the orderbook they are trading. This could be as simple as the average of the last 5 minutes of the mid-prices (the price right in between the highest buy and lowest sell in the orderbook).
In practice, they don’t want to buy higher than or sell lower than their reference price. If they do, they expect a loss. In order to be profitable, the maker cannot simply buy or sell at the reference price. Instead, they apply an offset on each side to push themselves away from this reference price, hoping that the market will still trade against their lower buys and higher sells.
Finally, depending on various conditions, they may decide to lean their buys and sells up or down. For example, if they believe the markets are about to surge, they would choose to lean their sell orders further away from the reference price and their buy orders closer.
So, how can the market maker choose the most optimal reference prices, offsets, and leans? That is where art meets science and is out of the scope for this “Long Story Short”.