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).

Theoretical price of Bitcoin

Products like CoveTrader calculate a theoretical value across a variety of different cryptocurrencies: Bitcoin (BTC-USD), Ethereum (ETH-USD), Litecoin (LTC-USD), Bitcoin Cash (BCH-USD), EOS (EOS-USD), Ethereum Classic (ETC-USD), and Ripple (XRP-USD). We take orders from a variety of different leading exchanges (including Coinbase, Kraken, Bitstamp, and others) and form a consolidated order book. We then examine the bids and offers, look for a certain notional size (e.g. $1 million in BTC), calculate the average price one could buy and sell that size, then average the prices to obtain a theoretical price.

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Trade difference ("Diff") or edge

The theoretical price then allows us to track all trades taking place in the market and compare the traded price to the theoretical price. This difference, or "Diff" as we call it in CoveTrader, can shed light into profitable trading moments where a trader was able to buy below the theoretical price or sell above it. For example, suppose the Theo 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 - Theo). 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.

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Execution quality

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:


About CoveTrader

CoveTrader is a platform for active traders of bitcoin and other cryptocurrencies. The crypto market is highly fragmented with dozens of exchanges and limited availability of trading tools. CoveTrader ties the market together in one powerful and transparent trading and analytics platform.

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