Market making refers to a trading strategy in which traders make profits when their market making strategy is executed in a relatively stable environment. Market makers create liquidity in the market by creating buy and sell limit orders. The bid-ask spread is usually how they make the profits. Spread refers to the difference in price between the bid and ask price. The market making strategy is quite simple – buy low, sell high. For instance, if a BTC is trading at $18,000, the market maker can create a buy order at 17,999 and a sell order at 18,002. When both orders get filled, the trader will make a $3 profit.
Relative profitability in the market making strategy is calculated as a percentage relative to the capital that is being used to trade. Let’s say you are a market maker who is ready to use $10,000 as your seed capital and are looking to trade the EOS/ETH pairs. Let’s also assume the 1 EOS is currently trading for $8 on an exchange that has a $0.26 spread. As we have already pointed out, one of the main strategies for market makers is to create two orders – one a buy order and the other a sell order. You can, therefore, create an $8 buy order and set your sell order at $8.26. When both of these orders execute, you will have earned $0.26.
In order to calculate your relative profitability, use the formula; spread /(2*price). In our example, the relative profitability will come to 1.625% for every trade that executes successfully. Not shabby at all, especially considering that you can keep doing this over and over again throughout the day. For instance, it is very possible to make up to 100 such trades in a single day.
Some popular exchanges almost always have a very thin spread and so are not very ideal for this market making strategy. For instance, an exchange that has a $0.01 spread will not give you any significant gains even if you were to make hundreds of trades in a day. Most market makers will, therefore, go for decentralized exchanges that have large spreads. For instance, doing a hundred trades on an exchange has a 1 cent spread will yield $644.74 while doing 100 such trades on an exchange that has a 26 cents spread will yield $50,125.17 on the same $10,000 investment.
What could go wrong?
For market making to be consistently profitable, the underlying digital asset needs to have a stable exchange rate. If the price of the asset goes t the moon or tanks, the strategy may not be as effective. When the prices of an asset start shooting, your buy low order will not get filled. Meanwhile, the sell order will fill at the price you had set and so you will miss out on the huge gains. On the flip side, when the digital assets start to tank, your sell order will not fill because everyone is trying to get rid of the coin. If you are running a bot and you do not stop it, you might end up filling the entire sell orders on the order book. That might sound good in theory but it might be disastrous if the coin ends up at $0 market cap
Market Making in Online Trading
Market making is as old as forex and stock trading. Because high-frequency market makers thrive in volatile environments, it makes perfect sense for them to be attracted to the cryptocurrency market. Initially, market making in cryptocurrency was mainly done by individual traders and online trading systems. However, the attractive conditions for market making in cryptocurrency have started attracted asset managers and other institutions on board.
You will not find any other market that is volatile as cryptocurrency. This means computer savvy firms and individuals can scalp profits in seconds as a result of the price oscillations on the markets. But the biggest hindrance for most traders is speed. A microsecond is all it takes to make huge gains or huge losses. For most traders, making some money on the cryptocurrency market is comparable to waiting for the proverbial London bus. But sticking with that analogy, one can wait for the bus for too long and then suddenly, two come along just a minute apart.
It is not uncommon for Bitcoin and other cryptocurrencies to get 10% gains or more in just a couple of hours. But what makes the cryptocurrency market so attractive is the fact that the prices rise and fall almost consistently. Cryptocurrency is, therefore, the bus that most market makers in the world of trading are looking to jump on as soon as the conditions are right for them. As an example, NEO, OMG and ETP once nose-dived by 90% in a matter of minutes before regaining the original position. Any trader who caught this made a huge killing.
The best way to take advantage of the volatility of the crypto market is to use market making trading bots. A market maker seeks to place both buy and sell orders in order to profit from the spread. A spread is defined as the difference in price between the topmost sell and buy prices that are on the order book. The spread is usually the profit. Market makers typically make such transactions all day long on the markets and this is how they create liquidity on the market.
A typical market maker doesn’t look to make huge percentage gains on a trade because that wouldn’t be feasible for the market making strategy. They seek to scalp something like 1%-2% gain on every trade. However, because they make lots of trades, the maths eventually adds up. For instance, a market maker can make 50%-200% gain in a single day just by making hundreds of trades.
It is not possible for the trader to manually place hundreds of trades every day. This is where trading bots come in handy. All reputable exchanges allow traders to connect to their APIs so implementing market making strategies using trading bots is relatively easy. The market maker will come up with a strategy that they have tested and the bot will execute the trade for them based on the conditions set. The cryptocurrency market never sleeps so a trading bot that is set correctly will make huge profits over and over again.