Market making and mean reversion

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...

• Type: Journal
• Year: 2011
• Where: SIGECOM
• Authors: Tanmoy Chakraborty, Michael Kearns
• Keywords: ECommerce, Mean Reversion, SIGECOM 2011, Theoretical Characterization, Time Series Models