I heard that market-makers — like TD Ameritrade and Fidelity – usually make profits while traders do not, especially in foreign exchange. Why is that?

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    It's just like how the casino makes a profit while gamblers always lose money on average. Day trading is indistinguishable from gambling. – vsz Aug 3 '20 at 9:37
  • @vsz 8 - Ignoring the bid/ask slippage, day trading is a zero sum game. The majority of day traders lose (aka gamblers) but a minority do well. A better analogy would be a casino's poker game where the house takes a small cut of each hand and that would be analogous to the slippage caused by the bid/ask spread. And similarly, the few players who are quite adept at poker take money from the inept players. – Bob Baerker Aug 3 '20 at 18:29
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    Wait, since when are TD Ameritrade and Fidelity market makers? I know they are brokers, but for a market maker i think of relatively unknown entities like the now defunct Knight Capital. – Michael Aug 3 '20 at 22:33

A market maker has several advantages:

  • Faster access to market news and they can change their price faster than you can

  • If they are the market, they buy at the bid and sell at the ask when the public transacts with them and they earn the spread.

  • They see the order book and can trade knowing the depth and size of the market.

  • They can arbitrage a position against a variety of securities: a basket of stocks, an ETF, or lay off the risk with options.

An example of the latter is conversions and reversals. If there's a buyer for calls, if the numbers line up, the market maker can buy the stock, buy the same series put and sell those calls to the buyer, locking in a risk free gain as possibly the B/A spread(s) as well. A reversal would involve a seller of puts.

  • Thanks! Can you elaborate on how knowing the depth and size of the market helps a market maker earn money? And in your example of a conversion, would the same trick if the buyer was for stocks and the MM sold the stocks to the buyer? And by virtue of owning the stock, do you have the ability to issue calls or puts for the stock at any price you choose? – Sean Taylor Aug 2 '20 at 19:58
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    If you see the order flow, you know whether there is buying or selling pressure. Google "Advantages of market makers" and read about what they can do compared to retail trade. A conversion or reversal is done to take advantage of mispriced options. That's what keeps option prices aligned (box spreads too). You can't arbitrarily just "issue calls or puts for the stock at any price you choose." A transaction requires a buyer and a seller. – Bob Baerker Aug 2 '20 at 20:43

Which traders? Quoting Lawrence Harris (bold is mine):

Market-makers provide liquidity to impatient traders. They try to turn their inventory at a profit. To profit, they must trade at prices that produce a balanced order flow on both sides of the bid/ask spread. They find these prices by experimentation. Their inventory turnover may be extremely high.

Market-makers lose to informed traders. Market-makers must carefully analyze order flow to identify informed traders. The task is difficult because orders typically are identified only by broker and not by beneficial trader. Market-makers widen their spreads to recover from uninformed traders what they lose to informed traders. This widening of the bid/ask spread is called the adverse selection spread component. Market-makers profit from impatient uninformed traders.

Successful market-makers must pay attention continuously. They must integrate information about the order flow, they must keep tract of their own positions, and they must make good decisions quickly.

Market-makers supply liquidity in the form of immediacy at the inside bid/ask spread. Because they fear trading with informed traders who they cannot identify, they are reluctant to offer liquidity to large traders.

Market-makers make prices more efficient through their efforts to find prices that produce balanced order flow. One-sided order flows often indicate that value-motivated traders or informed traders think securities are misvalued.

Market-makers are called dealers or specialists in the equity and options markets. They are called dealers in the bond markets and in the currency markets. In the futures markets they are often called scalpers or day traders.

If the computers are properly programmed, electronic traders profit when market-makers make mistakes. These mistakes typically occur when market-makers are not paying attention. Electronic traders often lose when market-makers have information about the order flow that is not transmitted in the electronic feeds. The proprietary models then may misinterpret market conditions. When electronic traders supply liquidity, they profit from impatient traders but they lose to informed traders.

Lawrence Harris, The winners and losers of the zero-sum game: the origins of trading profits, price efficiency and market liquidity [draft 0.911], May 7, 1993.


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