Option Trading: Pricing and Volatility Strategies and Techniques

CHAPTER 10

Market Making Techniques

In this chapter we will introduce and discuss the basic trading techniques that a high-frequency trader uses to extract value from his market. High frequency only makes sense as a relative term. It is the frequency where market microstructure is more important than any forecast of future market direction or volatility. This varies from product to product. If trading is analogous to a game of poker, high-frequency trading is the part of the game where we are playing our opponents rather than our cards.

Typically our aim in this type of trading is to capture the bid-ask spread. All traders try to buy low and sell high, but here “low” means on the bid and “high” means on the offer. This adds liquidity to the market. It is liquidity provision that these traders are paid for. Recently, this kind of trader has received a lot of bad press. Most of it was poorly informed and most of it was by people who do not have the ability to compete in this area. The disdain should not be too surprising. If the markets are an ecosystem, high frequency traders are the scavengers and decomposers. Their life is not glamorous or particularly noble, but they provide a service and markets would not function without them.

Some markets are far more amenable to the kind of techniques we describe here than others. There is no point attempting these maneuvers in a very illiquid product. In order to play games you need someone to play against. Liquid futures, where speculators ...