Options Market Makers

[safvan]

I was wondering how options market makers protect themselves for options that are expiring in the same month for large contract orders coming in.

Since the time premium is very low for a bit out of the money options expiring within the current month, how do they hedge themselves when the customer is right?

For example an option for apple thats expiring in august can be around $0.5 for 5 points out of the money, so if someone places an order of 100 contracts (cost is $5,000) that is a lot of money to be paid to the customer if he is correct and apple moves say 15 points within a week.

So thats a profit of around $145,000 (14.5 points for example) for an investment of $5,000.

If the investment was $5,000 or $50,000 or $5,000,000 or $50,000,000...it would cause problems wouldn't it?

 

[QuestOptions]

Traditionally the market maker makes money by the bid/ask spread.

Just like any business: they want to buy for less than what it is valued at and sell for more than it is valued at. They use the theoretical value as an estimate of what it is worth.

If option strike A has a theoretical value of .05 you might see a bid/ask .03b/.07a

They will then put on a conversion or reversal.
conversion: long underlying/long put/short call = flat
reversal: short underlying/short put/long call = flat
(the calls and puts are of the same strike)

In other cases they may hedge there risk and use the option Greeks as there guide.


They try not to be exposed to directional risk at all.

Two really great books that discuss market maker concepts and risk management are:

Options Trading The Hidden Reality by Charles Cottle
Dynamic Hedging by Nassim Taleb

 

[Martinghoul]

There's only one thing you can ultimately do and that's to widen bid/offer (including choosing not to quote, if they're too exposed to a particular strike) to give yourself an extra cushion. Sometimes it works, sometimes it doesn't and that's when you hear about mkt makers going bust.

 

[safvan]

Thanks. Anyways being right in the last week of expiration can make some healthy profits for the trader but can be tricky for market makers if the orders are big.

They can probably limit you by widening the bid/ask price so that is really i guess what can limit a traders ability to really make big money on short term moves.

 

[safvan]

I just find it fascinating that one can *opt* to buy virtually large percentage of worlds biggest companies with mere pennies in the last weeks of option expiration provided your orders go through. With well versed strategies bundled with strict loss management, one can make fortunes.

Leverage is dangerous...

 

[Martinghoul]

They're not large percentages, if weighted by the probability of your options expiring in the money. It's like saying that with a 1000 lottery tickets you're able to virtually win the jackpot. But yes, leverage and lottery tickets sometimes pay off big, but you need to be careful and take survivorship bias into account.

 

[QuestOptions]

I just find it fascinating that one can *opt* to buy virtually large percentage of worlds biggest companies with mere pennies in the last weeks of option expiration provided your orders go through. With well versed strategies bundled with strict loss management, one can make fortunes.

Leverage is dangerous...

check out this article I think you will like it: http://www.fxtsp.com/education/fx-t...ew-with-top-trader-nassim-nicholas-taleb.html

He basically made a fortune betting on unpredictable outcomes

 

[Martinghoul]

check out this article I think you will like it: http://www.fxtsp.com/education/fx-t...ew-with-top-trader-nassim-nicholas-taleb.html

He basically made a fortune betting on unpredictable outcomes

He proceeded to subsequently lose the same fortune by continuing to bet on unpredictable outcomes that never materialized.

 

[QuestOptions]

He proceeded to subsequently lose the same fortune by continuing to bet on unpredictable outcomes that never materialized.

Thanks for adding that Martinghoul. No strategy is perfect. The purpose of the link was to show why someone might be motivated to buy otm options with very little time till expiration.

I am not promoting or recommending the strategy to anyone.

The article stated he made a great deal of profits with the strategy but past results are not indicative of future outcomes.

I am more familiar with the Taleb's book Dynamic Hedging and some of his academic papers. I do not know about much about his trading track record.

My apologies if my last post sounded one-sided and thanks for balancing it out for me.

 

[Martinghoul]

Thanks for adding that Martinghoul. No strategy is perfect. The purpose of the link was to show why someone might be motivated to buy otm options with very little time till expiration.

I am not promoting or recommending the strategy to anyone.

The article stated he made a great deal of profits with the strategy but past results are not indicative of future outcomes.

I am more familiar with the Taleb's book Dynamic Hedging and some of his academic papers. I do not know about much about his trading track record.

My apologies if my last post sounded one-sided and thanks for balancing it out for me.

No problem... My remark wasn't a dig at what you said at all. I just wanted to point out that, in things like what we're discussing here, you always need to think about longer-term performance, rather than one-off hits.

 

[safvan]

Actually I think buying slightly out of the money options (say price is at $110 and you buy $115 strike that expires within the same month with say 2 weeks left) when your strategy gives a buy signal (the strategy has to involve getting and out within a few days) for an option expiring within the same month or the following month is profitable.

One just needs to do whatever suits them and is profitable for them to build the edge. A lot of things that work for one person do not work for another.

 

[Martinghoul]

Actually I think buying slightly out of the money options (say price is at $110 and you buy $115 strike that expires within the same month with say 2 weeks left) when your strategy gives a buy signal (the strategy has to involve getting and out within a few days) for an option expiring within the same month or the following month is profitable.

One just needs to do whatever suits them and is profitable for them to build the edge. A lot of things that work for one person do not work for another.

It's not about you, it's about the mkt and it all depends. There are no hard and fast rules for what works and what doesn't. Sometimes some OTM options get stupidly cheap and are very much worth buying. Sometimes OTM options are stupidly expensive and one shouldn't buy them for all the cookies in the world. Sometimes (and that's v v rare), they're so expensive, you should sell them (but gently).

 

[safvan]

It's not about you, it's about the mkt and it all depends. There are no hard and fast rules for what works and what doesn't. Sometimes some OTM options get stupidly cheap and are very much worth buying. Sometimes OTM options are stupidly expensive and one shouldn't buy them for all the cookies in the world. Sometimes (and that's v v rare), they're so expensive, you should sell them (but gently).

Good points.

 

[Martinghoul]

Good points.

Unfortunately, the edge is, basically, all about having your **** glued to the chair and your eyes to the screen .

 

[safvan]

Screen time is our field time for us money moochers...

 

[charliechan]

i used to be a registered options market maker some 12 years ago now.

all mm's are market (direction) neutral. as soon as a bid/offer is hit, you hedge in the underlying. you make your money between the difference in the option and the underlying, making sure you're delta neutral. thats the edge. there is no guess work or direction call.


eg if you get hit on a structure with a delta of +x, you trade -x underlying contracts, locking in a spread between the two (hopefully!!). obviously you have to keep an eye on gamma and deltas of your positions through to expiration and adjust your hedgeregularly as your delta's going to change over time.

youre definitely not making money between the bid/offer of the option because most options never trade more than a few times, and usually the paper is always on one side, and youre on the other, so there is very rarely the opportunity to buy and then sell an option. when that opportunity does come up, it's known as 'free money'! as soon as an option moves away from ATM, it will trade less and less as Im sure you know already

So, to answer the question:
Since the time premium is very low for a bit out of the money options expiring within the current month, how do they hedge themselves when the customer is right?

the answer is, they dont really care. Theyre quotes will always be at levels they know they can hedge at and make their money. if they lose on the options, they make on the underlying. either way, they have locked in a small profit. remember a mm is obliged to post quotes for 80% of the day (usually), so he has to quote at a level he knows he can lock in profit

these days, as technology advances, the mm are looking at other 'synthetic' (ie similar) markets in case they offer better pricing than the underlying - eg etf's another options structure etc.