Departmental Papers (CIS)

Date of this Version

6-2011

Document Type

Conference Paper

Comments

Chakraborty, T. & Kearns, M., Market Making and Mean Reversion, 12th ACM Conference on Electronic Commerce, June 2011, doi: 10.1145/1993574.1993622

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Abstract

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 yields positive expected profit, and also obtain stronger profit guarantees for a canonical stochastic mean reverting process, known as the Ornstein-Uhlenbeck (OU) process, as well as other stochastic mean reverting series studied in the finance literature. We also show that market making remains profitable in expectation for the OU process even if some realistic restrictions on trading frequency are placed on the market maker.

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Date Posted: 24 July 2012