«Market Making 101: Part 1

November 2, 2020 • ☕️ 1 min read

You buy a Bitcoin for \$8000 and sell it for \$8010.

You keep doing this all day. Buy for \$8000, sell for \$8010.

At 5 pm, you have sold 99 Bitcoins and made \$10x99 = \$990.

Let’s make it \$1000

You place an order to buy another Bitcoin for \$8000, thinking:

“Let me nail this last one and then I’ll go home. \$1000 dollar profit, baby.”

A guy named Joe approaches you and says:

“Sure. You can have this one for \$8000”.

You hand Joe the \$8000 and Joe hands you your Bitcoin.

You then place an offer to sell it for \$8010. Like you have done 99 times previously today. “Another \$10 of easy money”, you think.

Joe was smarter than you

Right when you have placed the offer, the price of Bitcoin crashes to \$7000.

You scowl: “Fuck, why did I do this?”

You just witnessed the adverse selection problem.

You had been buying and selling all day, making a fat profit.

Now, you’re left with one Bitcoin that you bought for \$8000 and which has a market value of \$7000.

Your net profit for the day is \$990-\$1000 = -\$10.

Market making seems like free money. Until adverse selection happens, and it’s not.

As a market maker, you need to be prepared for adverse selection.