Earlier quoted context omitted.
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 ac…
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?
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).