How do market makers arrive at the bid- ask spread?

Metalloyd

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I have read that the bid ask spread is dependent on the liquidity and the transactions costs, but have no idea how the liquidity/transaction costs actually translate into numbers.

Let us say that the current stock price of "GreekGod corporation" is $31.00.

For the month of february, the Call and Put option bid-ask spreads and strike prices are as given below.

GreekgodCorp.jpg


Now say if the liquidity has increased then what would be the option prices? If say the liquidity decreased then what would be the option price be? (both bid and ask).

What is the effect of Implied volatility on the option price or is it the other way around? One of the traders I talked to told me that option price is used to arive at the volatility (this statement was a bouncer for me). I mean what would the market maker do knowing the volatility?

Deltas: How would one hedge the above options using deltas?
 
i used to be an options mm years ago.

essentially, there are various theoretical pricing models. i used to used black-scholes. the mm adds his idea of skew and vol into the model and out pops all the prices for the strikes. so essentially, if 2 mm's views on vol are slightly different, so will their quoted prices. skew is basically a fine tune to the vol figure everybody (mm) uses.

as for deltas, the mm will typically use this to 'hedge' his position. eg if he buys 1000 puts in xyz with a delta of 0.2, he will buy 200 of xyz underlying with the hope of making some money between the option and underlying. each delta will also be given by the pricing model.
 
I actually think that this is one of the most common misconceptions about market makers. Market Makers do not come up with the price of the options, the public does. Believe it or not market making is a lot like running a sports book. Market Makers are just trying to find a price point that will have equal buyers and sellers and then take advantage of the bid ask spread. Our role is to try and smooth out the transition to this price point and to assist in finding that price. The above answer is correct in how market makers actually manage the paper flow, but the truth is you should be asking how does the public price options, because that who is really doing so.

Mark
http://www.option911.com
 
Well I am not talking about the price of the options. I am talking about what market makers do with the price. Say if the price of the option is $5.15,, what would be the bid ask spread and how have the market makers decided on the spread..
 
That depends on 3 things. What is the liquidty of the options and the stock in general. What is the delta of the option. I think one could call the real determining factor 'hedge risk'. The greater the hedge risk the wider the quote. Thus OTM options, in high liquidty options, that have high liquidity in the options would be the tightest spreads. Deep in the money options, in stocks that are illiquid that have illiquid options would have the widest spreads. (a good example, go to the spx options notice that the 70 delta calls and the corresponding 30 delta puts have very different widths). There are certainly other detirming factors, but this is probably the biggest driver.

Mark
http://www.option911.com
 
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