In the world of finance, market makers play a crucial role by providing liquidity to the market. They buy stock from customers who want to sell and sell to customers who want to buy. However, not all customers are created equal. If a market maker’s customers are mostly sophisticated hedge funds, they might have a lot of unpleasant days. These hedge funds are smart and large; when they buy stock, it usually goes up, and when they sell, it usually goes down. This means the market maker often ends up on the losing side of the trade.
On the other hand, if a market maker’s customers are less sophisticated and tend to make poor trading decisions, that’s a different story. When these customers sell stock, it often goes up, and when they buy, it often goes down. In this scenario, the market maker can profit handsomely. The obvious business model here is to find more of these “bad” counterparties. Take them out to steak dinners, make them feel valued, and offer them trading opportunities that satisfy their urge to gamble. The goal is to do as many trades as possible with them, but not so many that they blow up entirely. You want them to have enough fun that they keep coming back for more.
This business model is strikingly similar to that of a casino: nice dinners, fun games, and lots of edge. In finance, one way market makers find bad counterparties is through “payment for order flow.” If you trade stock on the stock exchange, you run the risk of trading with sophisticated hedge funds. But if you trade exclusively with the customers of a retail brokerage, you know that all your counterparties are retail traders. So, market makers pay those brokerages to trade with their customers. In fact, there is evidence that market makers even discriminate among retail customers, paying more to trade with the less sophisticated ones.
But market makers don’t just take their counterparties as they find them; they can work to encourage and develop bad ones. This often involves product development. If you build a product that does nothing for sophisticated professionals but is really good for noisy, addicted gamblers, you will attract exactly the right sort of counterparty. This arguably explains much of the crypto market.
A recent trend in the options market highlights this strategy. Zero-day-to-expiry (0dte) options let investors bet on whether a particular stock-market index will rise or fall by the end of the day. These options have drawn an enthusiastic following among amateur investors, even as skeptics call them a form of gambling. So far, the 0dte boom has been limited to options tied to indexes like the S&P 500 or Nasdaq-100. The next frontier could be options on individual stocks like Tesla or Nvidia.
For example, Michael McCaskill, a 48-year-old day trader and volleyball-programs coordinator in Louisville, Ky., trades short-dated options in hopes of hitting the jackpot. He’s intrigued by the prospect of more-frequent expirations on single-stock options. “The percentage gains are incredible,” said McCaskill, who has previously made profitable bets on GameStop, Netflix, and PayPal. “It’s the short-dated options that give you that, whether it’s weekly or daily.”
From the perspective of equity market makers, there are few more beautiful phrases in the English language than “day trader and volleyball-programs coordinator.” If someone like McCaskill walked into the offices of Susquehanna International Group and said, “Hi, I am a day trader and volleyball-programs coordinator from Louisville, Ky., and I love short-dated options, but I wish they were shorter-dated, can you help?”, they would treat him like a celebrity and give him anything he asked for. He is their muse.
As it happens, Susquehanna is salivating over single-stock 0dtes, but Robinhood is less enthusiastic. In closed-door industry meetings, retail brokerages like Robinhood Markets, Schwab, Tastytrade, and Morgan Stanley’s E*Trade have advocated for a cautious approach, concerned they could face a customer backlash if investors’ options trades blow up. Other firms, including Susquehanna International Group and Nasdaq, have actively promoted bringing daily expirations to single-stock options. Both market makers and exchanges stand to benefit from the volumes that could come from further growth in the 0dte phenomenon.
The retail brokers make money if their customers are happy; the market makers make money by trading against them. There is an overlap in their interests, but it is not complete. If Robinhood gives its customers new ways to lose money faster, that’s probably bad for Robinhood in the long term, but it’s very good for whoever is on the other side of those trades.
Understanding the motivations and strategies of different market participants is crucial for anyone involved in trading. Market makers thrive on finding and fostering bad counterparties, much like casinos thrive on attracting gamblers. By recognizing these dynamics, traders can better navigate the financial markets and make more informed decisions.
