Boy those retail traders are lucrative

Every professional trader and market maker loves retail traders. They are the most lucrative counterparties to have, which is another way of saying that these retail traders are being taken advantage of big time by the pros. But I didn’t realise just how profitable market making for retail traders is in practice.

A couple of years ago there was a public debate about Robinhood making money from selling its order flow to hedge funds and professional market making firms. How else did you think they can offer commission-free investing? Of course, they sell your data so that others can execute your trades (while taking a sizeable cut for themselves). Always remember, if the product is free to use, the user is the product.

Peter Hoffmann from the ECB and Stephan Jank from the Deutsche Bundesbank used their access to regulatory data in the German stock market to measure how much money dedicated retail market makers make from retail order flows. The chart below compares the average daily profit by retail market makers during trading hours and outside of regular trading hours with the average profit of hedge fund proprietary trading desks.

Profit and variation of profits

Source: Hoffmann and Jank (2024)

It is clear that the average daily revenue from retail market making is not much larger than the average revenue a prop. trader generates. But the revenues in the retail market are much less volatile. Average revenues for retail market makers during regular trading hours are about 10% higher than for institutional prop. traders but the variation of these revenues is about half.

Thus, as a risk-return trade-off, retail market making is incredibly attractive. The Sharpe Ratio of retail market making is in the order of 14 to 18 or about twice as high as the Sharpe Ratio of prop. trading. This is huge.

Sharpe Ratio of retail market makers in Germany

Source: Hoffmann and Jank (2024)

As a reminder, a Sharpe Ratio larger than 1.0 is what you would expect for a well-performing, well-diversified portfolio of stocks and bonds. Everything above 3.0 is considered excellent. Over the last three years, the Sharpe Ratio of the S&P 500 was 2.4, and for the DAX in Germany it was 1.75. These retail market makers achieve a risk return trade-off ten times as good as that!

I would be willing to pay a fortune to get access to that retail order flow book. And indeed, the study authors estimate that an institutional market maker would be willing to give up around 60% of their revenues to get access to this retail order flow. Even with this huge haircut, they would be more profitable than sticking with institutional order flow alone.