Advent of Alpha Idea 2: Market Making

Market making and the idea from Day 1, Bookmaking, are synonyms in the eyes of some in the context of a sports exchange. Traditional market making on a stock or commodity is buying at one price (high) and selling at another price (low).

When you “buy” on a sports exchange you’re “selling” everything else (assuming one winner on the market), so bookmaking by laying (selling) one selection is in effect buying everything else, because of how the market is settled.

On an exchange you can of course back and lay - or buy and sell - a single selection, as well with the additional peril that a one-side (or unbalanced), trade is effectively a back or lay on the rest of the market.

The basics are easy enough to understand: if you back a selection for £5 at 2.0 and lay it for £5 at 1.95, you will lock in a profit of about £0.25 before commission if the selection wins

In this example if both trades match, and your selection loses you will lose nothing. The profit comes from the selection winning only. There is a way to lock in a profit whether your selection wins or loses, but that’s a topic for another day later this month. For now, we’ll just assume you’re backing and laying the same amount at different prices.

I’m also not talking about swing trading (which we’ll come back to later in the month), where you’re saying “I think the price is going to move this way”. You’re just saying “I don’t know which way the market will move”, and putting up prices, and then adjusting your positions based on what gets matched.

Most finance texts on market making are long and inaccessible, but the short version is take a position which turns into inventory as your bets get matched, you then skew new positions as your inventory grows (so you lay more as your back inventory grows, and vice versa), and you hope at the end of it all you get rid of all your inventory as the market goes in play.

The real key here is to make sure that at the point you can’t trade any more - or don’t want to trade and more - your inventory is balanced. You could do this in some markets with BSP, letting your inventory balance out automatically. This sounds like a good idea, except you’re going to need to be at a liability of £10 at the moment the market goes in play which means you’re not able to validate with small stakes, and, you’re going to affect the price of BSP by being in the auction. If you’re on a market that goes in play, you might be able to persist and trade out for a while. You might also consider trading up to a few minutes before the off and then try and get rid of your inventory at whatever price you can.

An aside I might come back to later in this month as another idea is that BSP volumes are so low on some markets that you playing in that auction can really alter them for a while (until more liquidity comes in to counterparty you as other traders realise some idiot is over-betting BSP to the point of absurdity and there’s value in being on the other side at the auction), to the point where it might be an edge in itself to spot people doing this.

Let’s just agree then that this is a little trickier than it looks. Is it worth diving into?

At one meetup I helped arrange at Betfair HQ, Matthew Trenhaile suggested that there were “perhaps 3 or 4 decent market makers out there”, and they weren’t the same 3 or 4 all the time - you’d get something to work for a while, and then get replaced soon enough. C’est la vie, the cycle of life and so on.

When somebody very smart and experienced is telling you that something is really hard and you should look at something else, I think you have two choices: believe them, look elsewhere; or, perhaps they are doing that exact same thing themselves and don’t want their lunch eating, and you need to get stuck in and at least take a bite of their Club biscuit, if not their whole cheese sarnie.

I personally think on smaller markets (Matthew’s speciality - he seems to mostly work away from the very large volume sports), he might be right, but I am not convinced it’s that straight-forward when it comes to large liquidity markets like cricket, football or UK/IRE horse racing.

What made me think “this is probably doable”, is that some sharp sports books (think Pinnacle), make this the foundation of their business model. What they have in their advantage that you don’t have in yours is that they can set prices with a healthier over-round margin and be confident of getting matched. However, their mental model, the way they see a market and its prices, is something we can borrow from.

I’ve tried a few strategies around this and I do believe that like bookmaking, it’s possible with the right parameter search to get some alpha out of this. As a warning, I also think it might be harder than bookmaking.

One threat is adverse selection pricing: you’re making a price, somebody with more information then you thinks you’re dumb as bricks and takes the price, and you’re left holding a trade you can’t get out of in the time left available, without locking in a loss. The only way to really detect this is you find you end up stop lossing a lot - you can’t get your inventory balanced because you’re always getting pipped off. There are ways to manage this though. You’ll most likely want to explore sizing your risk up as the market gets tighter, and more stable, as the event off time gets close.

Coming out ahead - or even level - when the market goes in play or closes is another tricky factor. Your market making strategy is to build inventory (trades on both side of the book), that you time to have balanced out before you can no longer trade. As with all trading systems, you need to figure out all the ways you’ll exit (including your stop losses), before you enter. You almost certainly don’t want an unbalanced inventory to go in play (that’s just uninformed betting, amplifying the adverse selection problem), so you need to decide whether to try and make BSP work, or perhaps look to stop loss or close your inventory out a set time before the event starts. Those can be tricky parameters to find, as they might be market dependent: the more stable the prices, the more time you have to build inventory, most likely.

If you’re thinking about doing this, like bookmaking you’re going to need some data with matched volume to be able to back test it. Start small, but keep in mind if you’re hoping to enter the market auction for BSP, you’ll need to make sure your bets qualify for that all the way - you might have more luck making sure you don’t have any open trades before you get to that point, or managing your inventory in-play.