hissho said:
Hi Mag
after reading your posts i've got some more questions:
1) for those very liquid stocks(like top 20), are the bid/ask spread set by market makers or actually by hundreds of thousands of traders?
2) (following question 1) do market makers intervene and set bid/ask spread ONLY when the stock is not liquid enough?
3) on a very liquid stock, the bid/ask spread tend to be very narrow which means more efficiency. in this case, how can market makers widen the spread and squeeze you?
4) i keep hearing bad experiences with market makers such as they rip you off etc. but after doing some homework i found that "market makers are not something you want to beat; they are there to provide liquidity and thus making the market more efficient, not to rip you off"... what do you reckon? should i change my mindset from "it's our enemy; i should beat the bastard" to "they are just doing their jobs"?
any comments would be much appreciated,
hissho
Hello hissho,
Here are some answers to your questions:
hissho said:
1) for those very liquid stocks(like top 20), are the bid/ask spread set by market makers or actually by hundreds of thousands of traders?
The Bid and the Ask can be comprised of either a market maker’s or a non-market maker’s order, or both, at any given time. The thing to realise is that there are certain rules the market makers are obliged to follow.
But even in realatively illiquid flex designated stocks, you can at times have natural liquidity that are driven by non-market makers, but this density of this activity varies depending on each situation. Sure, on average the very liquid stocks tend to have more interest, hence more non-market maker orders in the system at various times.
So, if there is a lot of action in a specific option strike, you can have very tight spreads at times with many different players buying and selling in a “hot” period of activity.
hissho said:
2) (following question 1) do market makers intervene and set bid/ask spread ONLY when the stock is not liquid enough?
This depends on their obligations. In flex options, they may not interact at all if they don’t want to, but in markets that they have an obligation to make a market, they certainly can interact just like any other person or organisation can to buy or sell at a price.
Any buy order below the buy price of the bid, or any sell order above the sell price of the ask is unlikely to transact unless a big order sweeps all the existing orders out and is at the same level or deeper…
But sure, if there is a natural market in play, they may not transact at all, but still may have a bid and an offer, but it may be behind other orders. Certainly if it is not in their interest to do so.
Don’t forget, to make money they try to obtain a margin or gain some arbitrage or other benefit from the transaction one way or another. You may not know their strategy since they can operate on several different levels and in different markets you may not be aware of. As you can imagine this depends on a lot of variables, such as the market we are talking about, which particular organisation, and the current policy or strategy in place.
hissho said:
3) on a very liquid stock, the bid/ask spread tend to be very narrow which means more efficiency. in this case, how can market makers widen the spread and squeeze you?
In this case, they are probably more reliant on volume as opposed to widening the spread if there are a lot of orders in play in a “hot” market, hence you tend to be able to get narrower spreads.
What is often misunderstood though, is that it is not only the width of the spread that is important, but where the spread is located in relation to the current price of the underlying. The MM’s can actually keep the spread range the same, but move the centre of this spread up or down depending on the objective of the market maker.
If they think a lot of players are going to exit long calls for instance on a significant move up, they may drop the volatility and move the spread down…
If they think a lot of players are going to exit long calls for instance on a significant move Down, they may drop the volatility and move the spread down too…
If they think a lot of players are going to buy a strike, they may inflate the price, and move the centre of the spread up (move the volatility up).
Just try to think what you’d do in any market situation to maximise your margin as a market maker, and you’ll get the idea.
hissho said:
4) i keep hearing bad experiences with market makers such as they rip you off etc. but after doing some homework i found that "market makers are not something you want to beat; they are there to provide liquidity and thus making the market more efficient, not to rip you off"... what do you reckon? should i change my mindset from "it's our enemy; i should beat the bastard" to "they are just doing their jobs"?
As I said earlier, without market makers, you would have a very poor options market, and this could severely limit liquidity. I fully agree with Mofra’s viewpoint here. It is a trade off, having to pay slippage is as I said earlier a cost of doing business.
This is especially true if you are looking at long calls or puts with directional trades. As Mofra points out, there are strategies to combat this using spreads, but these also have trades offs like capped profits, and extra brokerage to be considered. A lot will depend on your trading style, and preferred approach. Volatility is also an aspect to be considered. Spreads can suffer from low volatility (especially when selling), as much as straight calls and puts can suffer from high volatility and volatility crush.
If you read my earlier comments I was not happy with a recent volatility crush, but at the same time I fully understand what the market maker is doing, and while I don’t like it because I’d prefer to have the profit in my pocket, I fully understand that they have every right to maximise their profits as any of us have, and on that level acknowledge it when they win a round. They are maximising their profit in a game that is clearly stated in the exchange rules.
In my view, carveat emptor. If you’re going to play in the options market, it is up to you to do the due diligence to understand the risks, and make market decisions accordingly. They provide a service, but do so at a price. They both have to make a living, and like us, want to maximise profits. That is the way of the market.
As happytrader quite wisely says, “try not to hold a grudge” or “get too distracted by what the other half is doing”. Couldn’t agree more. Take the emotion out of the process, and focus on what is going on, and success is more likely to find you!
Regards
Magdoran