Market making / scalping?

Has anyone here tried to build a trading strategy that is trying to capture the spread, like market makers do? This strategy is also called “scalping” I believe. I’m not asking about a strategy that enhances the return of a “traditional” P123 port, but I mean a strategy that only trades for the sake of profiting from the bid/ask spread.

The spread for micro/smallcaps is quite large, and commissions can be quite low when you add liquidity. (IB charges just 0.24 cents per share in that case, with commissions going even lower when you trade more.) It sounds plausible that all the big HFT guys focus on large caps and mostly ignore the micro/smallcaps. Volume can be quite low, so daily profits will not move the needle for those guys. So there may be an opportunity for smaller investors/traders like us.

There are a lot of people that day trade stocks for small gains per trade. I get the feeling most of those people are just gamblers, and most of them don’t really know what they’re doing. I don’t really trust what I read on other internet forums.

P123 can theoretically provide a big edge for this kind of strategy I think, because you can narrow down the set of stocks you trade so you’ll be less affected by “adverse selection”, which is a big risk for market makers.

I’m still deciding whether to pursue a strategy in this direction. Any experience/comments would be welcome!

Thanks,
Peter

I have some experience at “scalping” at index options. Things to consider:

  1. At “normal” times the market maker theoretically has the advantage of the (1/2) bid/ask spread (which is the disadvantage of the market hitter). The flip side of that advantage is of course the risk: When the market (stock) moves, the market maker might lose.
    The problem is you don’t know in advance when is the market going to move and by how much. Theoretically the market maker should put his orders at a spread which reflects those risks. The less the stock is tradable, the greater the risk (remember you also have to close positions).
    Some of the risk is theoretically possible to calculate statistically (by measuring past stock behaviour). Some isn’t, ie surprise events. But even the measurable risk is not a simple thing. It takes matematical models and computational resources, and it is dynamic. Unless you find stocks no one else bothers to look at (and those are the most risky by the above considerations) you will probably compete against more professional players aided by computers dynamically calculating the risks, responding to news, and moving orders at fractions of a second.
    Sorry for discouraging you, but I realy believe that’s a losing proposition.

yorama,

Thanks for replying. Did you try to trade index options of very liquid indices, like the S&P500? For very liquid equities / options, I definitely agree with you that it’s a losing proposition for non-professionals.

There is typically very little news for micro/smallcaps, besides their quarterly reports. I sometimes check Yahoo finance when I see a stock in my portfolio moving up or down a lot, and 9 times out of 10 there are no recent headlines.

The spread is also determined by the liquidity: the more often you can “flip” your position as a market maker, the narrower the spread can be to make the same profit. 1000 trades with 1 cent profit per trade is the same as 10 trades with one dollar profit per trade. If the liquidity is 100 times less, the spread needs to be 100 times more to get the same absolute profit. I cannot compete with professionals on 1 cent spreads, but if I get almost a dollar per share for each trade, I’d be happy even if I can make that trade for only a couple of hundred shares per week (per stock).

If you really want to do this, I suggest you learn Python and head over to Quantopian instead.

Peter,

I was a specialist/marker maker and I scalped stocks for a number of years. What I can tell you is that what you are attempting to do is not easy.Depending on the exchange market makers have certain advantages over you(ex. being able to participate on the bid/ask,lower costs). Also they tend to step ahead of your order by bettering the spread.
I have also placed a server at the exchange(co-located). I made money for a few years in Canada before the big boys came in and then I was pushed down the queue. It is tough to compete with those who are updating there hardware/software and networks every three months with million$ budgets. They used to be only in the large and liquid and now they are starting to move down to the smaller caps.
There is one way to compete that I know of a few who are doing and making money. What they do is place bids/offers on hundreds of stocks a certain percentage away from the market for those outlier trades. There is risk in this(i.e. flash crash) but with a few fail safe’s there is profit to be had.

Brian

mbclark, I already know Python quite well (I’m a software engineer). Quantopian is indeed much better for such strategies, but they only have the best bid/ask aggregated over minute intervals. I was kind of assuming I’d need real time level 2 data. Besides, I tried Quantopian a while ago and I found it extremely difficult to use (despite knowing Python well). It was just hard to debug and know what was really going on in your algo. Anyway, I might try it again if I want to test some ideas.

brett, thanks, that’s very helpful. I’m now leaning towards not investing (much) time in this…

Brett, Peter and all,

Can the retail investor get an edge over the market maker for a few of the stocks being studied with the new nickel spread? Specifically, there is a group of stocks where the market maker/institutional investor trade an $0.05 increments. The retail investor is exempt for some of these stocks—according to the simplified rules I have seen.

It seems that the retail investor could have quite an advantage with these 400 or so stocks. You would, in essence, trade between the BID/ASK spread buying from the institutions and selling to the market maker or another institutional investor-pocketing part of the nickel spread. I assume you might not be shorting stocks with the costs involved.

Just a thought—I don’t doubt that a closer look at the rules would prevent us from having and edge.

Jim

Jim,
I have not looked into these rules as this has not affected my trading but anecdotally I am not sure about the retail investor having this advantage. What I can tell you from my experience in helping to create trading rules at an exchange is that the retail investor has rarely if ever had a trading rule advantage over the market maker. If what you are saying is true then yes there would be an edge there but I doubt it would last long. Market makers are strong lobbyists.

Brian

Agreed. I have wondered myself what Trump might do. For now is scheduled to last 2 years for a small group of stocks. But much of this is meant to benefit the market maker. They like most of the nickel spread rules and want much of it to be expanded—albeit probably without any benefit to retail investors.

And I fully agree that a close look probably would not benefit the retail investor. For example, what are the rule for those who have to register as day traders? There is much that I do not know.

Thank you for sharing your experience!!!

Jim

I’ve had quite a bit of experience with the nickel spread over the last few weeks, and it’s not good. Today I had to pay about 3c per share more than I needed to for NTIP. I know without the nickel spread I could have bought it cheaper. And since I bought 7500 shares, the nickel spread cost me about $225 on the trade. Ouch.

Thanks Yuval,

You know more about this than I do. I agree this is really a problem.

For those not as familiar. NTIP is in Group 3 and and has a “trade at” requirement. I think this may means retail investors have fewer or no exemptions among other things.

$0.05 on a $3 stock 1.66% slippage. Yep you got Scr^$%3ed.

Market at the open has the same price for buyers and sellers. Can that help sometimes? I do not know the answer—a real question.

Thanks.

Jim

Jim -

There’s ALWAYS a bid/ask spread, no matter when you place your trade. In heavily traded stocks it’s a penny. In many stocks it’s now at least a nickel.

For all I know this may lower the bid/ask spread for certain securities by raising the volume traded. I think that’s FINRA’s idea. And I’m reasonably sure Renaissance Technologies has figured out how to make money off of this. Not me, though.

  • Yuval

I think this is true. But it is also important to know whether there is a market maker involved and whether the price for the purchase of an equity and the sale of the equity are the same.

I always get the price quoted as the open on Yahoo whether buying or selling when I place an order before the open. I understand there are exceptions for some people depending on their broker. But I always get the price quoted on Yahoo. One price with no spread for both buyer and seller.

This is due to what is called “the opening cross” for the NASDAQ and the NYSE. This is clearly a different process than a market maker using a BID/ASK spread. Fully automated on the NASDAQ with no human involved (no market maker or other human).

It is important that there is no money going to the market maker and that the prices are the same for buyer and seller.

Link to NASDAQ Opening and Closing Cross: http://www.nasdaqtrader.com/content/productsservices/trading/crosses/openclose_faqs.pdf

The problem with the nickel spread is that is becomes a huge spread—percentage wise–for stocks with low prices.

Peter,
When a stock moves, it doesn’t have to be in response to news in that particular stock. It can be a general market move, a sector move, news in another related stock, and sometimes it just moves because somebody decides to buy or sell a large amount. When it moves, you will just get the order excecuted, and see the stock move against you. You will not know which of the above scenarios is happening, and you will have to cover your position (the more you delay this, the more risk of a large move). And when you cover your position you will sometimes act as a market hitter, losing the theoretical bid ask spread you tried to earn :frowning:
Yoram

yorama,

That’s right. When I was thinking it through a bit more yesterday I realized that the stock will almost always move against you, like you say.

When a sell-off is starting, for whatever reason, I’ll be the first to buy, and then I’ll see the price dropping. I can only sell the shares again when the sell-off has stopped and people start buying again. But then I’ll be first one selling. So a very naive strategy would be buying at the tops and selling at the bottoms… that cannot end well.

brett’s suggestion of having bids or offers placed at a certain (probably fairly large) distance from the best bid/ask just to catch those outliers might work. But with low volume stocks that will probably lead to a tiny number of trades. So I’m probably better of putting more time in my P123 models and trade with the market instead of against it.

Thanks,
Peter

Jim,

Where can I find more information about which stocks have a nickel spread for which group of investors?

Peter,

Here is the link I use to look up the group a stock is in: [url=http://ftp://ftp.nyxdata.com/Tick_Pilot/Tick_Pilot_Historical/NYSE_Group_Tick_Pilot_Assignments.txt]ftp://ftp.nyxdata.com/Tick_Pilot/Tick_Pilot_Historical/NYSE_Group_Tick_Pilot_Assignments.txt[/url]

As far as links about the Tick Pilot Study, in general, I could give you some links but you will probably do better Googling “Tick Pilot Study” or “Nickel Spread Stocks.” And I am sure you have already done this.

Jim