Market making and mean reversion

12 years 7 months ago

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Market making refers broadly to trading strategies that seek to proﬁt by providing liquidity to other traders, while avoiding accumulating a large net position in a stock. In this paper, we study the proﬁtability of market making strategies in a variety of time series models for the evolution of a stock’s price. We ﬁrst provide a precise theoretical characterization of the proﬁtability of a simple and natural market making algorithm in the absence of any stochastic assumptions on price evolution. This characterization exhibits a trade-oﬀ between the positive eﬀect of local price ﬂuctuations and the negative eﬀect of net price change. We then use this general characterization to prove that market making is generally proﬁtable on mean reverting time series — time series with a tendency to revert to a long-term average. Mean reversion has been empirically observed in many markets, especially foreign exchange and commodities. We show that the slightest mean reversion...

Tanmoy Chakraborty, Michael Kearns

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