In this lesson, you will learn how market making works as an advanced trading strategy, why spread capture trading can be profitable, and what risks must be controlled before using it with real capital.
What Market Making Tries to Do
<strong>Market making</strong> means placing both buy and sell limit orders in a market so other traders can trade immediately. A <strong>limit order</strong> is an order to buy or sell at a specific price or better. The market maker earns when a buy order fills at a lower price and a sell order fills at a higher price.
The gap between the best buy price and best sell price is called the <strong>spread</strong>. For example:
A market maker may place a buy order at 99.91 and a sell order at 100.09. If both orders fill, the trader may capture part of the spread. This is why market making is often called <strong>spread capture trading</strong>.
A market making strategy is not simply about placing orders on both sides. The real skill is managing what happens when only one side fills. If your buy order fills but price keeps falling, you now hold an asset that is losing value. If your sell order fills but price keeps rising, you may be short or underexposed. The spread is the reward, but <strong>inventory risk</strong> is the cost.
Building a Market Making Quote
To understand how to market make, start with three basic inputs:
Example:
Your goal is to get filled on both sides over time. But your quote must be wide enough to cover:
If fees are 0.05% per trade, your spread must be larger than the round-trip fee. A round trip means buying and then selling, or selling and then buying back. If your spread is too tight, you may trade often but still lose after costs.
Advanced traders often adjust their quotes based on market conditions. In calm markets, they quote tighter spreads because price moves slowly. In fast markets, they quote wider spreads because the risk of sudden movement is higher.
Managing Inventory and Risk
<strong>Inventory</strong> is the asset position you hold while market making. If you are market making ETH/USDT and your buy orders keep filling, you will accumulate ETH. If sell orders keep filling, you will reduce ETH or build a short position if margin is used.
Good market makers do not let inventory grow without limits. They use rules such as:
<strong>Skewing</strong> means changing your buy and sell prices to encourage one side of trading. For example, if you hold too much ETH, you may place your sell order closer to the market and your buy order farther away. This makes selling more likely and buying less likely.
Example:
This helps reduce exposure without using a market order. A <strong>market order</strong> trades immediately at the best available price, but it usually pays the spread instead of earning it.
Another key risk is <strong>adverse selection</strong>. Imagine you are quoting BTC at 60,000 bid and 60,020 ask. A large sell order appears because informed traders know bad news is coming. Your bid fills at 60,000, but price quickly drops to 59,700. You earned no useful spread because the market moved against your inventory.
To reduce adverse selection, market makers may:
Practical Workflow for Real Traders
A practical market making workflow should be slow, measured, and data-based. Do not start by trying to compete with professional firms. Many large market makers use advanced software, direct exchange connections, and very low fees.
A realistic workflow:
1. <strong>Choose a liquid market.</strong> Liquidity means there are enough buyers and sellers to enter and exit without moving price too much. BTC/USDT and ETH/USDT are usually better than small tokens.
2. <strong>Measure the spread.</strong> Watch the average spread over different times of day. A market with no spread leaves little room for profit.
3. <strong>Calculate fees.</strong> Include maker fees, taker fees, funding costs if using perpetual futures, and withdrawal or transfer costs.
4. <strong>Backtest or paper trade.</strong> A <strong>backtest</strong> checks a strategy on historical data. Paper trading means practicing without real money.
5. <strong>Start with small size.</strong> Use the smallest size that gives useful data.
6. <strong>Track performance.</strong> Separate spread profits from inventory gains or losses.
For example, a trader practicing on a centralized exchange such as CoinW (https://www.coinw.com/en_US/register?r=3443555) could observe the BTC/USDT order book, record the bid-ask spread, and test small passive limit orders before increasing size.
Here is a simple tracking table:
This shows why market making can look profitable before inventory is included. If you only measure filled spreads, you may miss the main source of losses.
Advanced traders also compare <strong>realized profit</strong> and <strong>mark-to-market profit</strong>. Realized profit is from closed trades. Mark-to-market profit values your open inventory at the current market price. A market maker can show realized gains while holding a losing position, so both numbers matter.
When Market Making Works Best and Worst
Market making works best when markets are active but not chaotic. The ideal condition is enough trading volume for your orders to fill, but not so much directional pressure that price trends strongly against you.
It tends to work better when:
It tends to work poorly when:
In DeFi, market making can also happen through liquidity pools. A <strong>liquidity pool</strong> is a smart contract where traders swap against deposited assets. This is different from order book market making, but the idea is similar: you provide liquidity and earn fees. The major DeFi risk is <strong>impermanent loss</strong>, which happens when the value of your deposited assets changes compared with simply holding them. DeFi market making requires smart contract risk checks, pool volume analysis, and fee-versus-loss comparison.