hissho said:
hi
i'm very puzzled by the thing called "market makers" and would like to ask for some enlightenment. anyone here who used to work as a MM?
1) it's said that market makers are there to provide liquidity. is it correct? is providing liquidity their only job?
2) are market makers allowed to make money? there's a big difference between "they are allowed to make money if an opportunity presents itself" and "they are trying to make money WHENEVER possible"...
3) how can i tell if a bid-offer spread is put there by the market makers or natually by different bidders and sellers? i mean it's easy to tell when you can't find bid-offer prices---you just call your broker and request a quote--that quote must come from a market maker; but when you see a spread with bid-offer prices and with a very small open interest, for example 5, how can you tell?
4) do market makers do trades with other market makers? Will a market maker be able to tell(using their proprietary software) if a trade comes from another market maker or a private trader?
any help would be greatly appreciated,
hissho
Hello hissho,
In addition to the comments made on this thread, I’ll try to offer some additional information for you to consider.
Think about how an options market works. For a transaction to happen, two parties must take opposite sides of the contract for a trade to occur (we all know the basic definitions for calls and puts, don’t we?).
Liquidity in Options Markets:
How is this achieved? In order to ensure liquidity, exchanges grant market making licenses to trading organisations which fulfil certain requirements to be appointed, and carries a range of obligations contractually with the exchange.
This requirement varies between exchanges, but essentially requires a market maker to maintain a bid and an ask of a certain size (amount of available contracts) within a range of strikes from the current price, and with restrictions on how wide the spread can be from the bid to the ask.
How do MM’s Hedge?
So, how do market maker’s hedge? When you buy a call from a market maker, the market maker may hedge by buying some stock in the market. How much stock they buy will depend on their risk policies. If you buy an ATM (at the money) call, they may only buy around 500 units of stock (assuming Australian 1000 shares per contract) since the delta will probably be around 50% (the option will move 5 cents to a 10 cent move in the underlying).
If you bought an OTM (out of the money) call with a 30% delta, they may only buy 300 units of stock to hedge for example. But as spitrader1 points out they are still at risk with interest rates and volatility shifts, but they can hedge these two in a number of ways using structured financial products, futures, bonds, etc.
The way market makers deal with dividends is generally to adjust the volatility levels, reducing the volatility of call values incrementally as they near exdiv (and resetting post exdiv to normal), and increasing the volatility proportionally as they near exdiv (again resetting post exdiv).
On any given trading day, a good market maker usually has an algorithm set up to take into account the entire aggregated effect of long calls, short calls, long puts, short puts, and long/short stock they are holding, at different strike levels and different expiry times. They can adjust the theoretical exposure to be as nearly hedged as possible, or can adopt a policy direction if they have a market view and be skewed either long or short the stock based on the configuration of the overall positions.
Think about how a bookie works when taking bets on two football teams. They may offer $8 return to a $10 bet to win in a 50/50 game. They are hedged if one person bets these odds on team A, and another person bets on team “B”. They take $2 profit, and can’t lose. They pay the winner their original $10 back, plus the $8 win, and keep the $10 form the loser, making $2 profit. This is how market makers with options aim to profit from the bid and ask spread.
Of course giving odds in a horse race is more complex, and a little more like the options market. If someone buys 10 ATM put contracts, and you buy 10 ATM call contracts, of the same stock at the same time, these can essentially reduce the risks as the stock moves.
Think about how bookies work at the racetrack by offering odds. Market makers work in a similar way to make money, generally by pushing the buy price higher than fair value based on the current price of the underlying, and the current volatility levels, and the same for the sell price – pushing it lower.
Different market makers can be making a market for the same options series, and you can find one is offering the bid, and the other is offering the ask, with each others other side being further out than the other. This effectively reduces the spread when it happens. A lot depends on how aggressive a market maker is, and what kind of policy they adopt in terms of exposure.
It is entirely possible for one market maker to trade with another (just like a bookie does) to hedge risk. Think about a bookie that takes two bets on a 100-1 odd horse. They may make one bet with another bookie to reduce their exposure. The same is true for Market makers. They may transact with anyone in order to hedge a position. It is more likely that they will look to do this using shares though.
The market maker’s aim is to make as much margin on each transaction as possible– if you are offering a trade which hedges another trade on the opposite side, you may get set around fair value or better, especially if there is a lot of activity on the other side of the market (i.e you’re entering bullishly while the majority are taking bearish action). But if you’re exiting on stop, and they see you coming, they may widen the spread, or skew it as people get shaken out of positions. This is partly how they can maximise their profits.
Another thing to think about is that in less liquid stocks, your transaction size will be based on the availability of stock. For instance, if buying puts, the market maker will try to sell a corresponding amount of stocks in the market, hence they will be looking at the available shares on the bid to hedge, depending on the expiry date and where the strike is (ITM, ATM, OTM).
So, if you’re looking to buy 10 ATM put contracts, and only 2500 shares are available on the bid, they may only transact 5 contracts at that point, if the theoretical margin is sufficient. If not they may not transact with you at all. Just keep this in mind when you get a partial fill.
The availability of shares to hedge the opposite side may be a determining factor of where you will get set if there isn’t any activity in other options. Also, if others are looking to take a similar position to yours, but at a different strike, this may reduce the available shares to hedge too. The more players, the more difficult it is for you to monitor. Hence you can get set at some amazing prices if you work out the plays for the whole range of options and stock…
I hope that gives you all food for thought!
Regards
Magdoran
P.S. Margaret, this may illustrate some of my thinking about how to play the market makers that you have been asking me… hope it helps. Mag