Market Making: Exploit Them

Centralized exchanges rely heavily on market makers (MMs) to provide liquidity and facilitate trading. Market makers are traders or firms that continuously place bids and offers, creating a market for assets and ensuring that other participants can execute trades. Their positions, known as 'inventory,' reflect their net long or net short exposure on any given asset. Market makers often receive compensation from exchanges through bonuses or direct payments for reaching certain trading volumes, and they typically incur minimal to no trading fees.

While market making offers numerous benefits, it also entails significant risks. By understanding these risks, traders can potentially exploit them to their advantage.

Risks Faced by Market Makers

1. Capital Risk: Market makers require substantial capital. If the exchange experiences a failure or a 'rug pull,' they could lose all their funds.

2. Lag Risk: Exchanges may encounter downtimes, API issues, or glitches that can severely impact the automated trading systems used by market makers.

3. Volatility Risk: The high volatility of altcoins can result in drastic price changes within minutes, posing significant risks to market makers who might lose everything before they can hedge.

4. Hedging Costs: Hedging isn't cheap. Even with low fees, frequent large-size hedging can result in slippage, eating into the profits of market makers.

5. Liquidity Risk: Balancing inventory can be challenging, especially in large sizes, potentially trapping market makers in unwanted positions.

6. Basis Risk: Basis is the percentage difference between spot and futures (perpetuals in crypto). A sudden expansion in basis can adversely affect the profitability of market makers.

Hedging Strategies for Market Makers

1. Perpetual and Spot Hedging: Market makers can maintain a delta-neutral position by being short in the perpetual market and long in the spot market. This approach can keep costs lower and streamline fund management on a single exchange.

2. Multi-Exchange Hedging: Market makers might provide liquidity on one exchange and hedge on another. Alternatively, they can adjust positions across multiple exchanges to maintain a delta-neutral stance.

Exploiting Market Makers

Taking Advantage of Basis Risk

During strong uptrends, market makers often find themselves shorting perpetual contracts and buying spot to hedge their net short inventory. This dynamic creates opportunities for traders to exploit.

• Strategy: When a perpetual asset surges more than the rest of the market, you can 'buy basis' before market makers do by shorting the perp and buying spot. This can be particularly profitable during significant uptrends.

Example: Suppose you notice a wild uptrend in TRB’s basis indicator, showing that the spot price is significantly higher than its perpetual contract. By shorting the perp and buying spot at this moment, you can achieve substantial returns before market makers adjust their positions.

Exiting the Trade: When volume begins to decline and the asset price starts to drop, it might be time to exit the basis trade by closing the short perp and selling the spot.

Short Squeezes: Another speculative strategy involves identifying potential short squeezes. When the basis becomes highly positive, indicating that many market makers are net short on perps, a sudden upmove can force large players out of their positions. You can exploit this by longing perps or placing high offers to get filled during a price spike.

By understanding the intricacies of market making and the associated risks, traders can identify and exploit opportunities for profit. These strategies provide valuable insights into how the MM system operates and offer potential alpha for savvy traders.