MARKET MAKING WITH ALPHA SIGNALS

Álvaro Cartea and Yixuan Wang ()
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Álvaro Cartea: Mathematical Institute, University of Oxford, Oxford, UK2Oxford-Man Institute of Quantitative Finance, Oxford, UK
Yixuan Wang: Mathematical Institute, University of Oxford, Oxford, UK

International Journal of Theoretical and Applied Finance (IJTAF), 2020, vol. 23, issue 03, 1-26

Abstract: We show how a market maker employs information about the momentum in the price of the asset (i.e. alpha signal) to make decisions in their liquidity provision strategy in an order-driven electronic market. The momentum in the midprice of the asset depends on the execution of liquidity taking orders and the arrival of news. Buy market orders (MOs) exert a short-lived upward pressure on the midprice, whereas sell MOs exert a short-lived downward pressure on the midprice. We employ Nasdaq high-frequency data to estimate model parameters and to illustrate the performance of the market making strategy. The market maker employs the alpha signal to minimise adverse selection costs, execute directional trades in anticipation of price changes, and to manage inventory risk. As the market maker increases their tolerance to inventory risk, the expected profits that stem from the alpha signal increase because the strategy employs more speculative MOs and performs more roundtrip trades with limit orders.

Keywords: Market making; alpha signal; high-frequency trading; momentum trading; order flow; adverse selection; latent alpha (search for similar items in EconPapers)
Date: 2020
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Citations: View citations in EconPapers (9)

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DOI: 10.1142/S0219024920500168

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