How Market Makers Choose Their Markets & Strategies

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Written By
Contributor Image
Written By
Dan Buckley
Dan Buckley is an US-based trader, consultant, and part-time writer with a background in macroeconomics and mathematical finance. He trades and writes about a variety of asset classes, including equities, fixed income, commodities, currencies, and interest rates. As a writer, his goal is to explain trading and finance concepts in levels of detail that could appeal to a range of audiences, from novice traders to those with more experienced backgrounds.

We look at how market makers choose their markets and strategies.


Key Takeaways – How Market Makers Choose Their Markets & Strategies

  • Liquidity and Volume
    • Market makers select markets with high liquidity and volume to ensure enough trading activity for tight bid-ask spreads and minimal holding times for securities.
  • Risk Management
    • They use sophisticated risk management strategies to control potential losses from holding inventory in volatile conditions.
  • Market Selection
    • Market makers select their strategies based on a dynamic evaluation of market data, volatility, industry relationships, and their own expertise.
    • Use algorithms for pattern recognition and arbitrage opportunities to optimize their presence in suitable markets.
  • Controlling Fees
    • Market makers indirectly influence the fees they earn through strategies that manage bid-ask spreads, select optimal markets, and use exchange incentives, rather than directly controlling transaction fees.


How Market Makers Choose Their Markets

Spreads & Transaction Volume

Ideally, they would look for a balance between:

  • Wider Spreads – Larger spreads can mean more profit per trade. However, very wide spreads can discourage trading activity.
  • High Transaction Volume – More frequent trades translate to more opportunities to capture the spread and generate profit. Nevertheless, very high-volume markets can be fiercely competitive, and hard to consistently secure buy and sell orders at favorable prices.

Spreads & Liquidity

The sweet spot for a market maker is a market with:

  • Reasonable Spreads – Wide enough to be profitable but not so wide that they scare away potential traders.
  • Good Liquidity – Enough ongoing buying and selling to ensure a steady stream of trades and capture the spread efficiently.


Some factors market makers consider when choosing their top markets:

  • Asset Volatility – Moderately volatile assets can offer opportunities for wider spreads as prices fluctuate. However, excessively volatile assets carry significant risk of price swings that could lead to losses.
  • Order Book Depth – Markets with a healthy depth of buy and sell orders at various price points indicate good liquidity and potential for frequent trades.
  • Competition – Less competition from other market makers allows for potentially better control over bid-ask spreads and capturing more of the profit.

In essence, market makers look for markets with a good balance between the potential for profit per trade and the ease of executing those trades.

It’s not just about the biggest spread or the highest volume, but finding a market that allows them to capitalize on their strategies effectively.


How Market Makers Choose Their Strategies

Here’s a breakdown of the different ways market makers find the markets most suitable for their strategies:

Analyzing Market Data

  • Spread Analysis – Market makers use data feeds and specialized software to track bid-ask spreads across various securities and exchanges. They look for assets with consistent, reasonably sized spreads.
  • Volume Tracking – They closely monitor trading volume to gauge liquidity. This helps identify markets with sufficient activity to support their trading strategies.

Volatility Studies

Market makers analyze historical volatility data to identify assets that offer the right balance of price movement and risk that aligns with their appetite.

Networking & Industry Relationships

  • Exchanges – Market makers often cultivate relationships with exchanges. Exchanges may incentivize market making in certain assets by providing data access, reduced fees, or other benefits to bring in liquidity.
  • BrokersBrokers often have data and insights into which markets are attracting trading activity and where there might be a need for additional market-making services.
  • Other Market Makers – Collaboration or informal communication within the market-making community can help identify emerging opportunities in less crowded markets.

Expertise & Niche Focus

  • Asset Specialization – Some market makers specialize in particular asset classes like stocks, bonds, options, or specific sectors. This deep understanding of those sectors allows them to identify profitable opportunities.
  • Geographic Focus – Some market makers concentrate on specific exchanges or regional markets, allowing them to gain better insight into the dynamics of those trading environments.

Technology & Algorithms

  • Pattern Recognition – Market makers use algorithms to scan large amounts of market data to spot trends and anomalies that might indicate potential opportunities in different markets.
  • Arbitrage Detection – Algorithms can identify pricing discrepancies across different exchanges or between related financial instruments, creating temporary arbitrage opportunities for market makers to exploit.


Market discovery for market makers isn’t a static process.

It requires constant monitoring of available markets, technological advancements, and strategic shifts to optimize their presence in the right markets.


How Market Makers Control Their Fees

Market makers don’t directly control transaction fees in the traditional sense.

However, their strategies and the overall market structure indirectly influence the fees they earn.

Here’s how:

The Bid-Ask Spread

This is the key factor.

Market makers profit from the difference between the bid (price they are willing to buy) and ask (price they are willing to sell) prices they set for an asset.

A wider spread translates to a larger potential profit on each trade.

Market Making Strategies

They employ various strategies to influence the spread and capture more of the transaction fee:

  • Order Placement – By strategically placing buy and sell orders, they can influence the bid-ask spread and create a more favorable environment for their trades.
  • Inventory Management – Carefully managing their holdings of an asset allows them to potentially widen the spread during periods of lower liquidity.

Market Selection

Market makers choose markets with:

  • Reasonable Spreads – Wide enough to be profitable but not so wide as to deter trading activity.
  • Good Liquidity – Enough ongoing buying and selling to ensure a steady stream of trades.
  • Lower Competition – Fewer competing market makers allow for more control over spreads.

Exchange Fee Structures

While they can’t directly control exchange fees, some exchanges offer incentives for market making activity.

This could include:

  • Reduced trading fees
  • Rebates for providing liquidity
  • Priority order placement

Market Efficiency

In efficient markets with numerous participants, spreads tend to be tighter due to competition (e.g., SPY).

Market makers may have to rely on high-volume trading to make a profit with narrower spreads.

Key Takeaway

Market makers don’t set transaction fees in the way a brokerage might.

Instead, they employ various strategies and market selection techniques to indirectly influence the spread they capture within the existing fee structure.