Spread, volatility, and volume relationship in financial markets and market making profit optimization

TL;DR

This paper investigates how spread, volatility, and volume interact in financial markets, modeling their relationships and optimizing market-making profits through microstructural parameters.

Contribution

It introduces a model linking bid-ask spread and high-low bars to microstructural factors, enabling spread optimization for profit maximization.

Findings

Spread depends on order liquidity and impact.

Adding liquidity reduces spread at low volumes, then worsens it.

Model connects microstructure parameters to trading volume and volatility.

Abstract

We study the relationship between price spread, volatility and trading volume. We find that spread forms as a result of interplay between order liquidity and order impact. When trading volume is small adding more liquidity helps improve price accuracy and reduce spread, but after some point additional liquidity begins to deteriorate price. The model allows to connect the bid-ask spread and high-low bars to measurable microstructural parameters and express their dependence on trading volume, volatility and time horizon. Using the established relations, we address the operating spread optimization problem to maximize market-making profit.