How do Market Makers Make Money Trading Bitcoin?
What is a Market Maker?
Before founding Cove Markets, I worked for 14 years at IMC, one of the largest market makers in the world. There is an excellent 2 minute video on IMC's website that explains what a market maker is. In short, market makers are professionals who provide two-sided liquidity, i.e. orders to both buy and sell, the difference of which is the bid-ask spread. They make money from this spread, not from forecasting where prices will go in the future.
Concept of Theoretical Price
Market makers are able to make money in any asset class, whether it's stocks, bonds, options, or even cryptocurrencies. To do this they need to calculate an unbiased theoretical price by considering a number of key inputs. These include short-term supply and demand, trading activity across multiple exchanges, and data from related instruments. Then they need to place orders to buy and sell in the most efficient way as possible, sometimes by placing limit orders around the theoretical price, other times by performing arbitrage by selling expensive products (or on expensive exchanges) and buying cheap products (or on cheap exchanges).
The CoveTrader platform calculates a theoretical price, which is referred to as True Price. This is done across a variety of different cryptocurrencies, including Bitcoin (BTC-USD), Ethereum (ETH-USD), Litecoin (LTC-USD), and Bitcoin Cash (BCH-USD). We calculate a True Price per exchange, as well as on the aggregate book.
True Price then allows us to track all trades taking place in the market and compare the traded price to True Price. This difference, or "Diff" as we call it, can shed light into profitable trading moments where a trader was able to buy below True Price or sell above it. For example, suppose the True Price is 6374.82 at the moment a trade occurs at a Price of 6380.05. The Diff for that trade would be +5.23 (= Price - True Price). This difference multiplied by the traded size (e.g. Total (BTC)) equals the instantaneous profit on the trade. With every trade, there is a chance of the market moving for or against the position, therefore market makers try to do as many trades as possible and hope to lock-in some of this difference, sometimes called "edge" across their total trade activity.
You can read more about True Price and Diff here.
Many traders of Bitcoin and other cryptocurrencies should invest more time and effort towards achieving good execution quality. While there might be long-term uncertainly in the price of these instruments, there are many clear examples of bad execution where traders are giving up free money to professionals. Cove Markets shares examples of these trades, like the one below, on our Twitter feed @CoveMarkets.
Some of these examples have been picked up by media outlets like NewsBTC: