Market Making

Market making is a strategy where a trader continuously offers to buy at one price (the bid) and sell at a slightly higher price (the ask). When both sides trade, the market maker earns the difference, the bid ask spread. Market makers provide liquidity, so other traders can buy or sell immediately. The Market Makers and Liquidity Providers lesson explains their role in market structure; this lesson explains how market making works as a trading strategy and why it is harder than it looks.

The basic idea#

The two big risks#

Inventory risk#

A market maker who buys more than they sell builds a long position (inventory). If the price moves against that inventory, losses can exceed many spreads' worth of profit. Market makers manage this by:

• Skewing quotes: if long, lowering both bid and ask to encourage buyers and discourage sellers.
• Hedging: offsetting inventory with related instruments, such as futures or ETFs.
• Inventory limits: stopping quoting on one side when position limits are reached.

Adverse selection#

Some traders who trade with a market maker know more, for example about news or large orders coming. When an informed trader buys, the price tends to keep rising after the trade, so the market maker loses. This is called adverse selection or being "picked off". Wider spreads compensate for it; faster reaction to new information reduces it. See Price Discovery.

What determines the spread#

How modern market making works#

Most market making in stocks, futures, options and FX is done by firms using automated systems. Their key edges:

• Speed: updating quotes faster than others when prices change. See Latency in Trading and High-Frequency Trading.
• Queue position: orders placed earlier at a price get filled first. See Fill Probability and Queue Position.
• Models: estimating fair value from related instruments, order flow and volatility.
• Exchange rebates: some exchanges pay liquidity providers a small rebate per share.

Options market makers also manage risk exposures known as Greeks, hedging delta and managing gamma and vega across many strikes. See Delta Hedging and Market Maker and Options Trader.

Market making in crypto and prediction markets#

In crypto, market making happens on both centralised exchanges and automated market makers in decentralised finance, where liquidity providers deposit tokens into pools. On prediction markets such as Polymarket, liquidity providers post limit orders on both sides of yes and no outcomes, and some platforms pay rewards for providing liquidity near the midpoint. The same risks apply: inventory and informed traders. See DeFi Basics and How Polymarket Works.

Can individuals make markets?#

In theory, anyone placing limit orders on both sides is making a market. In practice, competing with professional firms in liquid markets is very difficult because of speed and cost advantages. Opportunities for individuals tend to be in less liquid markets with wider spreads, where adverse selection and inventory risk are also higher.

Common mistakes#

• Ignoring inventory risk, letting positions grow during trends.
• Underestimating adverse selection, where most fills come right before adverse moves.
• Quoting through news events without widening spreads.
• Forgetting fees, which can exceed the spread.

Frequently asked questions#

What is market making?#

A strategy that continuously quotes buy and sell prices and earns the bid ask spread when both sides trade.

How do market makers make money?#

By capturing the spread across many trades, plus exchange rebates, while managing inventory and avoiding being picked off by informed traders.

What is adverse selection in market making?#

The tendency for a market maker's trades to be with better informed traders, so that prices move against the market maker after the trade.

Next, learn how traders position around scheduled and unscheduled events in Event-Driven Trading.