MM knowledge - microprice and fair value:

I sometimes get asked on the best fair value metric to use. The options typically include:
- mark price
- mid price
- weighted mid price
- microprice
In general, for liquid instruments mid price is usually correct. Maybe there are questions about how to do it cross exchange (volume weighted, OI weighted, maybe some custom method), but it is the generally accepted standard.
In options you often find less liquid options are best to use the mark price or some weighted mid price because they’ll be heavily skewed in their book. You can play around with this - it’s probably mid when it comes to liquid options or perhaps weighted mid as well (you can toy with this, I shouldn’t think it’s the question that decides profitability - if there even is one), but for illiquids it will matter a lot more.
Now, we get to microprice. Microprice I think is both smart and stupid. The smart part is the part that Stoikov didn’t invent and has been done for a long time before he published. That is the idea of quoting around the future fair value (forecast) and not just the current.
The silly part is his hidden Markov model- I don’t think this is useful and it’s certainly not what constructing a forecast for an MM looks like in production.
For a typical forecast model, we might use ridge (at a basic level) and then combine various features ranging from orderbook imbalance to more niche ideas. For our horizon:
That’s going to be derived from two things. Our markouts, and our holding times. If our markouts stop getting worse by much after 5 seconds then we care about 5 seconds, but if you only hold it for 3 seconds then we probably care about 3 seconds. You’ll have various horizon forecasts and you’ll skew around them anyways, but the most important ones are so because they cost you money (your markouts say so, and you are expected to be holding the position during that part of the markout).
I have written much more on this topic on my blog www dot algos dot org which has various in depth articles on how market making works from a practitioners view. Feel free to have a look.
Thanks for reading :))