How Do Market Makers Work? Trade Like a Bookie

Every Tuesday Chuck releases a new Trader Tip video on YouTube. This week we will discuss how Market Maker/Specialist exhibits similar behavior to the commercial but in much smaller time horizons. The Market Maker is driven by order flow and the desire to make a small profit over and over in exchange for facilitating orders.

You can read the episode transcript below or watch the video that follows.
If you have any questions, please reach out to us. We look forward to being a continued part of your trading education!

Today we’re gonna learn how to trade like a bookie, you know, like one of those guys you see in the movies, wears like a fur coat drives a Cadillac Eldorado. In all seriousness, today we’re going to talk about how a market maker trades. A lot of traders look at the market and they know about market makers, but they don’t really know what the market maker does, or more specifically, how they do what they do. How do they trade?

I started off my career working for market makers, and then being a market maker myself and building a really large market making operation. So I have a lot of experience knowing how market making operations work, and so I’m going to share some insights into you today to understand how market makers work.

To get this knowledge across to you, we’re going to use an analogy of a bookie of a sports bookie. So first of all, let’s talk about a market maker, sometimes called specialist to although there’s a lot less specialist now than it used to be. A market maker is somebody who is constantly providing liquidity to the market. They’re providing two sided liquidity, they’re giving a bid, and they’re giving an offer.

Now a market maker exhibits a similar behavior to a commercial firm, but in much smaller time horizons. So what that means is that market makers will tend to buy and buy lower, and sell and sell higher. They do the opposite of what the typical retail traders taught. Tetail traders taught don’t average down don’t average losers. But most market makers actually do average their losers they buy and buy lower and they sell and sell higher.

Now, market makers are driven by order flow. That is their primary asset, and that order flow comes a couple different ways. It can come electronically, where they use algorithms to be able to detect orders coming through the market, other algorithms. Or they use order flow such as inside information and talking with people, and seeing large orders come through the market via over the counter relationships. Both of these forms of order flow are incredibly valuable, and it’s fair to say that order flow is the backbone of most market makers and proprietary trading firms. Everything they do revolves around getting order flow.

Then what they do is they desire to make a small profit over and over and over again, in exchange for facilitating orders. So when I had my firm, we literally made 1000s and 1000s of trades every single day. We were constantly making trades in multiple markets all the time. We were collecting small amounts of money over and over and over, but if you do that enough, it adds up to an enormous amount of money.

So in our analogy, market makers are similar in many ways to a sports bookie, and what’s interesting is, I teach an advanced technical class and we this is actually right out of one of our lessons where we talk about the different participants in the market, and what is their role? And it’s interesting when I ask people, do you know how a sports bookie works? Most people actually don’t know. Which I think is fascinating. But people who gamble particularly people gamble on sports, they understand how sports bookie works. So for our purposes, it’s actually worth understanding how a sports bookie operates.

First of all, the sports bookies job is to facilitate betting by taking the other side of bets that the betters wanted to place. In exchange for taking the other side. They get paid what is called the VIG or the vigorish. So there’s a link here to Wikipedia, you can read about the vigorish or the VIG. One of the things I said about market makers is that they are driven by order flow.

Now, if we think about a sports bookie, a sports bookie is driven by betters, by orderflow from betters. So, whether it’s a sports bookie or it’s a sports book at a casino, if you don’t have people betting on games, you don’t make any money. Market makers are the same way. If there’s nobody making bets or making trades in the market, the market maker doesn’t make any money. So the market maker has a profitability relationship that’s direct with volume. It’s also actually almost parabolic as it relates to volatility, but definitely relates to volume. There’s no volume, the market maker doesn’t make any money.

Let’s look at the definition of the vig, and we’re going to focus on the second definition, which is vigorish, which is used in gambling. It’s when wagering on a straight wager you can lay a certain amount of money to win a smaller amount of money. The difference between what is wagered and what is won is called the VIG or the juice. So the vig is one of the ways a sports bookie makes money. So in football, basketball, this is varied from sports book to sports book, but the vig is usually about 10%. So in other words, for every $110 you wager, you win $100, or for every $100, you wager you win 90. If you lose the wager, you lose $110. But if you win, you only win 100. You basically get the 110, refunded to you, plus a $10 fee to get 110 back plus 100. So if you bet 110, you get to 210 back, you get your money back, plus 100. So there’s a small amount that went to the bookie. Now, what’s really interesting about this, is that if we actually look one of the reasons I like this as a model is really good bookies have no ego about the bets.

They really don’t care.

In our Facebook lives, I’ve had a couple different live sessions, one in particular, which I said it’s all about the math. It’s not about where we think the markets gonna go, or what our opinion is or what our system is. It’s simply about the math. The math trumps the method. This is the same thing here. If we look at what the bookies doing, it’s all about the math. The bookie wants to collect the vig over and over and over again, and the bookie really doesn’t give a shit who wins the game. Not when everything’s working as it should, it’s just about collecting the vig, so they have no ego about this.

Let’s look at an example to give us some context. We’re going to look at an NBA basketball game between the Dallas Mavericks and the Miami. So Dallas is playing at Miami, and Miami is a three point favor. Now this example is going to be extremely simplified just to get the point. In practice would be a lot more dynamic than this, but it’ll make the point. So Miami is a three point favor. So in the basketball game tonight, Miami’s favor to win by three points. That means that if Dallas wins, or if Dallas loses, but they lose by less than three points, anybody betting on Dallas wins. They win the bat.

Let’s talk about ideally how this works. Ideally, a bookie would have people on both sides, Dallas and Miami, placing bets. And ideally, the way it would work is there would be $100,000 Bet on Dallas, and there’d be $100,000 Bet on Miami. This would be what we call a balanced book. This is what the bookie wants. The bookie wants a balanced book. So, in this case, let’s say Dallas wins by five points. Well, in this case, the bookie makes $10,000 which is 10% of the vig, there’s $100,000 back he gets 10% of that the Dallas better makes $90,000 and the Miami better loses 100,000. So they each put up 100,000 And basically the Miami better doesn’t get their money back. The Dallas better gets his 100,000 back plus 90,000 There’s 10,000 accounted for that. 10,000 is the vig 10,000 plus 90,000 plus 100,000 is 200,000. That’s the total amount bet. Okay, so if the bookie balances the book, he makes the 10 grand and he’s happy. That’s what he wants.

So let’s look at a couple other scenarios. Because one interesting thing is when you look at sports lines, you’ll hear people say like I don’t know how those bookies do it. Like their lines are always so accurate. They must be geniuses. Well, they understand what they’re doing, but more than being a genius, they’re just having no ego and you’re going to see this here.

We want the book to be balanced but sometimes the batting line is off balance.

Let’s examine what happens. So in our game, the betters are consistently betting on Dallas because they’re an underdog. So they’re betting $100,000 on Dallas to win. But there’s nobody that wants to bet on Miami. Giving three points away. So the bookies job is to balance the book, not predict who will win. They don’t care. That’s why I say they have no ego. Their job is to balance the book. At this point, the bookies book is out of balance by $100,000. There’s 100,000 Bet on Dallas and zero on Miami. So what he needs to do to get his risk down is he needs to facilitate people to bet on Miami. So to get people to bet on Miami, he has to move the line in favor of Miami. So Miami was a three point favorite. And in our example, what he does is he takes the wind and he moves it from three to two to one and eventually to even where now if you bet Miami even you win. So once he gets the line down to zero, all of a sudden you see money come in to bet on Miami. So at this point, $100,000 gets bet on Miami, there was already $100,000 bet on Dallas. Now the book is balanced. There’s $100,000 in bets on both sides. So the bookie was able to reduce his risk by moving the line.

Now he has the book bounce, but there’s one issue and that is there’s a pocket of prices between Miami giving three or Dallas getting three and break even, the line being even where the bookie can lose on both bets. Okay, so in extremes he’s gonna get as vig, but if it comes in between 0 and 3 He could literally lose on both.

Let’s go through some of these examples.

Scenario One: Dallas wins outright. Or Dallas loses by less than three points. In this case, Dallas betters win 90,000, Miami betters lose 100,000 and the bookie makes 10,000. Everything is good.

Scenario Two: If Miami wins by more than three points, Miami betters win 90,000 Dallas betters lose 100,000 and the bookie still gets his 10,000 Everything is good.

Scenario Three: Miami wins but they win by less than three points. So it lands in this space between zero and three. In this example, the Miami better wins 90,000, The Dallas better wins 90,000, but the bookie loses 180,000. So what happens is the Miami better wins 100 But he only gets 90 Because he had to pay the vig. The Dallas better wins but he only gets 90 Because he has to pay the vig. So the bookie is collecting the vig in this case twice. He’s collecting 20,000. But even though he collected twice the vig he lost both sides. So he loses $180,000. One of the things we’re always talking about is the reward to risk ratio. So it’s interesting is that in this example, the reward to risk ratio for the bookie is 1:18, which is awful, it is terrible. So the bookie really does not want this scenario to happen.

We made this simple and extreme. So you could see the point. But in practice, the bookie is going to work to minimize this risk. And he has three ways to do this.

1. He can limit the amount bet that he will accept at any given line. This is the position size, so he can limit the position size. Initially $100,000 was bet on Dallas where he could be like, no, no, no, no, I will only take $10,000 that’s the most outtake. Now, he needs to take a bet big enough or big batters will never come back to him. He needs to facilitate trade by taking bigger orders that you might want, and market makers in the same boat. To facilitate clients, a lot of times market makers have to take bets bigger, trades bigger than what they want. But they still have to limit the amount they can take on or they’re going to get in trouble. So they limit the amount that they will accept for a bet at any given line.

2. They can move the line quickly. So in our example $100,000 is allowed to build up a plus three. But the reality is, is the bookie may say no no, no. I’m only gonna take 10,000 at three and I’m immediately going to lower it to two and a half and only do 10,000 at 2 and a half. And then if I get that I’ll be lowered to two and I’ll only do 10,002 And have a lower to one and a half. Maybe I go all the way to zero. But he’s going to move the line until he can get people to bet Miami and he’s going to do it quickly and dynamically, because this will limit his risk.

3. He can lay the imbalance off on another bookie. Bookies always know what the lines are in other books. Otherwise, there’s an arbitrage. They’re not just going to make up a number. They’re going to have a number they give to their client. But they’re also going to be aware of what is the line at Caesars or golden nugget or wherever the case may be, they’re going to know what the line is. If they end up taking a bet that’s too big, they’re going to get out of the phone quick and they going to lay it off. Sometimes they might be able to scratch it. Sometimes they might be locking in a small loss, but they don’t care, because they’re limiting the risk.

So three ways they can do this. All these three ways are the exact same ways that a market maker lays off their list. They limit their risk. They limit the position size. They move the market quickly, and if it gets too big, they lay it off on another market maker. You can see that the way the bookie operates, this is how a market maker operates. The big difference is that a market maker is compensated by being able to buy the bid and sell the offer, rather than receiving a vig. The market maker doesn’t give a pure vig, like in a sports bookie, but what they do get is they get the difference between the bid ask spread. So let’s say you want to buy Amazon stock, and you want to make sure that the trade is filled. If you want to make sure you’re going to get filled, you need to buy the offer. If someone else wants to sell, they’re going to need to sell at the bid. The market maker has the benefit of selling to you. You have to pay the offer he sells to you. And then literally maybe just even a second later he’s buying it back from somebody else. As soon as the market maker sells to you, he’s gonna want to lay that risk off to eliminate the outside risk of the market moving. He’ll do that either by buying back from a seller or having other places that he can lay off the risk for minimal cost.

Just as a bookie moves the line, market makers move their fair values.

They’ll move the market around. And just like a bookie will move the line against himself to facilitate trade to balance the book, a market maker would do the same thing. He will move his fear values against himself. So if a market maker is something worth 10 in the market is 975 bid at 10 and a quarter, and he’s able to finance 975s. Usually he immediately, and this often happens in automated sense in the model, the market maker will move the fair value down from 10 to 990. He’ll move it against himself, which will help him avoid accumulating large inventory and give him a better chance of selling for a profit.

A specialist is like a market maker.

The difference is the market maker competes with a bunch of other market makers. The specialist is giving the right to be the market maker, and not only is he the market maker, he gets to see the whole book. He knows where all the buyers are and he knows where all the sellers are. His job is to match up buyers and sellers and use his buying and selling himself to make sure everybody gets filled.

The specialist sees all resting orders.

Market maker can see orders, but he doesn’t necessarily see all of them, and he doesn’t know who’s doing it. The specialist sees everything. He sees all the orders and he knows who’s doing it. He’s basically given the whole puzzle, and he could use this to set up his own trades, but in return, he has to make sure the market is always orderly. This is why you’ll see a stock all of a sudden suspend trading. You don’t really see future suspend trading, where there’s all market makers compete against one another, but the specialist, he could suspend trading and why does he do that? He suspends it because he looks at the book and he goes, Oh my gosh, there’s no way I can balance this book without you losing a lot of money. So I’ll suspend trading. That’ll draw some other buyers or sellers in and I’ll move the price while it’s closed, and then I’ll reopen it at a level where I know it will facilitate trade and that protects his ass. So being a specialist is an unbelievably profitable business. You’re seeing less and less of these but they still are out there.

Another thing with market makers is they often trade a relationship game. So we mentioned Amazon, but they don’t just usually trade Amazon, they usually trade a bunch of things. It could be Amazon against Amazon options, where they can spread all these off against each other. Or, like in this case, let’s say we’re talking about Microsoft. They may trade Google against Microsoft or Google against Apple. They may trade Google against the XLC basket or Microsoft against the XLK basket. When they buy one in one place, they immediately can sell somewhere else, both around their fair value. This is one aspect that most retail traders don’t understand.

If a large order comes into one product, it gets diffused across an array of correlated products. Let’s say a large order comes in to sell ES. The market maker may buy ES. But as he buys, even if futures he’s Amelie selling spy, NASDAQ, QQQ’s, YM, DIA, VXX, maybe the big names in SPY. He’ll be selling all of these. He will be selling options in them, and so he can buy one big order and literally lay it off in 5, 10, 20 places. This allows him to buy size because he has multiple places to lay IT off. The more places to go with the order, the more aggressive he can be in taking risks.

There’s a lot that goes in is. If you trade on platforms like RobinHood, or you trade at places like Schwab or TD Ameritrade, it’s good to understand that there’s a market maker in the background is like a specialist to some degree, trading, against all of your order flow, and we’ll talk about this more next week on Trader Tip Tuesday. We’ll talk about payment for order flow. We’ll talk about fractional shares, and what all that means for you. So there’s a ton of information here that really helps educate you of how to understand market makers work in the market. So process this and see what ideas you can use from this to help you trade better, and remember, tune in every Tuesday for additional webinars such as this. I’m going to continue to continue to teach you different ways to think about trading that can help you take your performance to an elite level.

Thanks for joining and I’ll see you next Tuesday.
~Chuck Whitman