You buy a Bitcoin for $8000 and sell it for $8010.
You just made a $10.
You keep doing this all day. Buy for $8000, sell for $8010.
At 5 pm, you have sold 99 Bitcoins and made $10x99 = $990.
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.
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.
Joe was more informed than you. He knew the price was about to crash. You had no idea.
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.
You need to be able to adjust your bid and your ask (collectively known as your spread) so that adverse selection doesn’t rob you of all of your hard-earned gains.
There are various strategies on doing this.
In the next part of this series we’ll cover a few of them.