T2W Trading Community

Market Makers
One major area of misunderstanding is market makers. The market maker takes a risk by pricing and selling an option. The response by the market to the offering causes the market maker to make adjustments to the price. They have two goals… make as many traders as possible and try to make some money on most of the trades. They have two tools to try and make this work; the bid / ask spread and the cost of time. The market maker is taking the risk by entering into a contract with risk. They lay off that risk ASAP by either buying the same option (sell a 45 call and buy a 45 call) or buying stock to deliver in case of exercise. They neutralize their risk and collect a small premium for the transaction. If the buying and/or selling pressure, (coming from brokers and/or traders) starts to change they respond by pricing to meet the market action. They don't know you, or stock you. They need you and don't care if you make money or not. They just want your order flow. Many myths abound about market makers and you need to understand them and their motives.

Volatility
Option pricing is most sensitive to volatility. The theoretical option price is derived using a historical volatility, usually 12 months. The model pricing reflects that time frame. Short term option trading and pricing is being done in an environment that is subject to current market whims and conditions.

The current climate can be very volatile and the long-term picture can be quite stable. That throws the pricing model off dramatically, but it is a tip to savvy traders. If the short term is more volatile than the historical, the prices will be pumped up and become expensive and unstable. Extra time value is pumped temporarily into the option to reflect the current conditions (higher perceived volatility). If the price action calms down or stabilizes, the "Fluff" can be drawn back out very quickly. For example, rising prices calm the market and reduce fear and volatility. The typical option trader does not see this and then feels violated and cheated when their stock moves in the direction of their trade and they don't get the expected profit in the option. The market breathes a sigh and the volatility shrinks taking their profit with it.

An irony in the discrepancy between theoretical/fair value and the actual price is that the actual price is feeding the 12 month volatility and constantly adjusting it. Today's erratic volatility will be smoothed into the ongoing, ever-adjusting, 12-month moving volatility number.

In my next article, I will introduce the X Factor Options Trading Graph and show you how to put all this stuff into a picture format. Pictures are easy to digest a lot of data (e.g. stock charts). My students often say, "Trading options without X Factor is like trading stocks without a chart".

Options can seem simple as long as you don't learn too much. But they can seem overwhelming if you try to learn too much. There is a happy medium. The ten year old does not have to become a manufacturer to start the car, but he does need some practice and maturing to get behind the wheel.