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I work at a market maker, and what you say is mostly correct. However, I would like to add that retail customers get better prices not primarily because they move less volume (though this is certainly a factor), but because their order flow is significantly less toxic. Retail traders don't really know anything and their order flow contains less alpha, so market makers can quote better prices to them without getting run over.

It's very important for market makers to separate out order flows and assign a toxicity to each flow. This way, they can provide tighter spreads and better execution on less toxic flows while being a little looser for highly toxic institutional flows.

Just to check my own understanding...

So roughly, the idea is that if I’m smart money (say a big hedge fund or institutional trader), behind any of my trades is an implication that I know something worthwhile. So my trades will move the market, and this can leave market makers holding the bag if prices move quickly.

But if I‘m the proverbial dentist, my trades are just noise that don’t signal anything real about the market. I can get better execution because market makers aren’t worried about my trades moving the price out from under them.

Am I in the right neighborhood here?

You are putting it almost exactly how Matt Levine puts it.

I would just sneak in the point that, to my understanding --- and the previous commenter would know better than I do --- one of the big information advantages institutional traders have is simply the knowledge that their order is the first of 1000 identical orders they're about to follow up with.

Yes, this is also a good point. Retail trades are more likely to express real demand. When a retail traders puts in an order for 135 shares, say, it's most likely that's an accurate and complete signal of that traders intentions: they are looking to buy 135 shares. For institutional players, it could be an iceberg order: once the 135 shares are filled, the refill the order with another 135, again and again. So the actual orders they submit are less representative of their actual intent, making handling their trades much more risky.

What's the specific risk when handling these trades? Is it that the quoted price should be higher, given that there is more demand than there seems to be?

If that's the risk, though, it's not a risk of loosing money you have, but rather a risk of not making as much money as you could by selling at a higher price, right?

No it's the risk of losing money.

So let's say I'm quoting a tight spread and a small buy order comes in and I get hit. No problem. I don't adjust my quotes because that small of order will not impact the price. But now more orders are coming in from the same institution, buying more and more (basically one big meta-order broken up into small orders so as to conceal intent). If I don't realize that all of these small orders are from the same institution and that they actually represent one big order, I will probably lose money because I am treating each order in isolation. Everytime I sell to the buyer, the price goes up, making me lose money because my spread is too tight and I haven't identified the true intent of the buyer. Every time I sell, I am increasing my short exposure to the asset/derivative, so if the price moves up (against me), I am in a very real sense losing money.

If I can identify the meta order, I can shift my quotes up in order to compensate for the price impact all these small orders are going to have (remember, though they are individually small, they actually represent one big order).

So basically, market making is a game of predicting the short term future price of a security, and quoting buy/sell offers at appropriate levels. The less volatile and less toxic and more liquid a market is, the tighter I can quote. The more volatile and toxic a market is (and less liquid), the looser my spread must be. Remember that I'm not trying to make money on the directional moves of an asset (I'm trying to be "delta neutral"), but rather profit off of the bid-ask spread. My goal is to turn over inventory as quickly as possible (ideally buying and selling at the same exact time).

So if someone's buying a stock, the market maker actually takes a short position to make it available to the buyer? I was under the impression that market makers are just connecting market and limit orders with each other, is that not the case?

It's really complicated and I don't want to go into too much detail, but no, a market maker isn't "connecting" limit orders. A market maker is a market participant, just like me or you (well, sort of). They buy things and sell things, they don't have magical powers.

People get confused, but most hft firms utilize market making strategies. A market maker is just someone who puts limit orders on the book (making) vs taking liquidity off of the book (takeout). Anyone can be a market maker, and many firms do both market making and taking.

No, the exchange already matches a buy at market order to the best limit sell. A market maker is who is filling up the order books with offers to buy and sell at different prices under the hope that a regular trader will come in later with a trade the other direction at a better price.

Gotcha, that makes sense. Thanks!

Yep, that's pretty much spot on.

Although Im sure the improvement isnt that significant per trade, is it worth trying to game this to lower my toxicity, i.e. use odd lots, break up my trade etc?

Nah probably not. But if you use IBKR, you can use their best efforts VWAP execution algo: https://www.interactivebrokers.com/en/index.php?f=1124

My understanding is that it's not that the trades themselves will move the market, but it's likely that the market will move.

what does alpha mean here?

alpha here means "information"

FWIW InteractiveBrokers, in their Pro accounts (the one you pay albeit very low commission fees for) doesn't accept payment for order flow. Their Lite accounts (the one they launched to compete with RobinHood) do accept PFOF. [1, 2]

[1] https://www.reuters.com/article/us-usa-brokers-fees-idUSKBN1...

[2] https://gdcdyn.interactivebrokers.com/Universal/servlet/Regi...

IB Pro is the reason I used the word "virtually". :P

Makes sense, I'm just shilling; I like IBKR. Not, you know, their app or website. Their order execution, margin rates and other features (debit card, bill pay) are really solid.

And hey, no PFOF.

It's like a 0.3c/share difference between IBKR Pro and the price improvement you'd get at any other brokerage, right?

I haven't check it honestly, I don't really trade equities - I mostly sell equity options and index futures options. I use IBKR because of their low margin rates (1.25% for a 300K margin loan at the moment), their low commissions and their generous portfolio margin allowances.

Why IBKR over, say Schwab or Vanguard?

https://www.schwab.com/legal/order-routing-1

Crispier fills. And you can choose which exchange you route your orders to so you can get rebates (maker/taker model). Getting paid to open/close options positions is genius.

Depends on the size of your account and how you trade, and what you're looking to get out of it.

If you have an account value of over $110,000 IBKR will offer you the industry's lowest margin rates (as low as 0.75%, tax deductible) and very competitive order pricing, without PFOF. Of course with a substantial account you can ask any of them to match IBKR margin rates and they likely will.

I sell a lot of margin-secured put options for passive income, and having a 15% portfolio margin maintenance requirement gives me a lot of headroom -- not that I'd ever max it out, I just don't want to be anywhere close. Further the margin impact of out of the money options is also calculated generously.

They also offer access to basically any product in any market anywhere in the world. I sell index futures options in the US for instance, but if you want to trade on Canadian, European, Australian or Asian exchanges, it's just a button click away.

You can also practice tax-aware borrowing and use their debit card to make purchases against your margin, and also, they offer bill pay which works against your margin balance too. My personal economy involves holding a 6-month cash buffer in my bank account, and investing anything that comes in - and borrowing against it to pay bills. Then, I use the proceeds from my short-term options trades, and dividends from my longer-term positions, to pay them off.

Just to be annoying here:

You keep saying that a benefit of IBKR Pro is "no PFOF". That's true --- IBKR Pro is I think the only online retail brokerage that doesn't do that.

To my understanding, the only meaningful benefit to "no PFOF" is potentially better price improvement. Which is to say, if you place orders with Ameritrade, which is doing PFOF, you're going to get price improvement over NBBO, but with IBKR Pro, which doesn't, you might get even better price improvement.

In the IBKR Pro case, that's true: according to their advertised price improvement stats, you will get 1/3c of improved price improvement per share as a consequence of trading through them compared to the industry average. Your call whether a third of a penny is meaningful to you.

But in the general case, it might not necessarily be true that "no PFOF" is a benefit; it's all a question of the fees you pay and the price improvement you get with a given brokerage's routing, right?

Am I off here? My sort of baseline belief is that firms like Citadel and Virtu are in fact very good at executing retail orders, and that it'd be weird to have a goal of making sure your dumb retail orders were routed around them.

Not annoying at all, I appreciate you pushing for clarity. I believe you are correct, I’ll do some research too.

IBKR does some of its trading off-exchange like the PFOF types, but they do it in-house, not on a paid-for basis. If you see "SMART" in the routing of an order on IBKR pro, often that order went to one of their darkpools or was filled by them off-exchange (at a price better than the NBBO).

The price improvement per share also sometimes comes from exchange rebates that they pass through to customers.

Pedantically, Vanguard Broker Services, the equities broker for Vanguard hasn’t to my knowledge ever gotten PFOF.

Their options broker has and Vanguard is on record as being pro PFOF so it’s not a moral stance and could change any quarter without notice.

I bought a house last year and long story short ended up not selling my condo, meaning to close I needed to not sell a chunk of my investments. Problem is, many had significant capital gains. I ended up just taking a margin loan for a blended rate of about 1%. I avoided capital gains, the margin interest is deductible, and my tech heavy portfolio has increased substantially in absolute terms and on a percentage return basis is crushing it.

I was comfortable with margin/leverage, for a few years I was very successful with a strategy of buying blue chip dividend stocks on margin and essentially running a credit spread trade- it's not for everyone.

But IB is outstanding compared to other brokers around things like this- it really excel for the "prosumer" niche.

That's how I made the down payment on my condo too. It's a heck of a deal! Especially when your portfolio skyrockets afterwards. YMMV ofc.

Does Vanguard provide an api? I use them for my three fund portfolio but use td ameritrade for swing trading as I can automate my strategy. Would be nice to keep it all in vanguard.

There are some pretty fine hairs being split here between different kinds of "best".

But just for reference I thought Robinhood took all of the improvement! So their marketing definitely wasn't universally misleading.

Why don't brokers place orders directly with the exchange? Is it more efficient to do it via market makers?

(1) There are lots of different exchanges and trading venues, not just one.

(2) Electronic market makers have expertise in order execution and have invested huge amounts of money in software platforms to automate it, which they're effectively renting out to broker-dealers.

(3) Some of these firms have other sources of inventory they can clear trades against.

There are probably 10 other more important reasons I just don't know about.

What I think it comes down to is that order execution is a big job, and being able to effectively answer the phone and run the right billboards and TV ads is also a big job, and firms like Citadel and Virtu are good at the former and firms like Ameritrade are good at the latter.

>20/80 is worse than other retail brokerages (virtually all of which do PFOF, because none of them are especially competent at actually executing trades) --- even if you factor in the lack of trading fees,

(1) I don't think you can make a blanket statement about the split and trading fees. If I bought 1 stock for $100 this year I'm better off with the 20/80 split than a trade commission. Conversely, if I bought 10,000 shares @ $100 I would be better off paying a commission and getting a 80/20 split.

It's also not clear what's better for the consumer. If I'm paying a commission then I have to trade sub-optimally in order to batch trades. Maybe I'm better off being able to make a trade for free when I need it even if it costs me more in fees.

(2) This seems like an odd standard. I can take 20% as a rebate because everyone else does, but I can't take 80% because no one else does that. So maybe I can take 25% or maybe 30% or maybe 35% and that's ok. Where exactly is the line?

And if someone launches a competitor called Jesse James and they take 80% does that mean Robinhood is now ok? Or is two not enough? And if two is not enough then how many does it take?

I'm literally quoting the SEC here. 80/20 wasn't an example I came up with for funsies. They did the math; the outcomes were worse for RH customers. Which seems like it would have been OK, except that RH said the opposite thing in its promotional material.