Basic options market maker question

Discussion in 'Options' started by Alex the Great, May 1, 2010.

  1. It is my understanding that option writers and option buyers are matched through a clearing house. What then is the role of an "options market maker"? I'm having a difficult time understanding their job. Do they simply stand ready to buy or sell certain options when no one else will?
     
  2. MTE

    MTE

    Essentially market maker is the liquidity provider of last resort. If noone is willing to sell an option and a buyer comes in the market then market maker will take the other side (i.e. sell the option).

    The role of the clearing house is not to match buyer and sellers in the market, but to be the counterparty to all buyers and sellers, thus eliminating the counterparty credit risk.
     
  3. please explain a bit more:
    I have an old car that nobody is willing to buy.
    Why is there no Market Maker for it.
     
  4. Aren't there used cars dealers?
     
  5. MTE

    MTE

    What does an old car have to do with options?

    As it has been pointed out above, there are used car dealers who would buy the car from you, you may not like the price, but there are buyers.
     
  6. But if each party trades with clearing house as their counterparty shouldn't the clearing house then do the matching of buyers and sellers for the final settlement?
     
  7. For the moment consider the following:

    You play a game where there are two players, and a third that flips a coin. For each heads the flipper puts a dollar into the pot. The other two parties are now going to bid and ask.

    Say we have ten flips, then using probabilities there will be 5 dollars in the pot. One party is going to sell the pot, and the other party is going to buy the pot. The seller will have to anty up the coins in the pot and the buyer will get the pot of coins.

    Before we flip the seller will say "I will sell you the pot for 6 dollars" whereas the buyer says "I will pay you 4 dollars". Each of them knows that the current probability is 5 dollars and they want to make money.

    You are at a stalemate because the buyer and seller want to make money. Enter the market maker. The market maker "has pixie dust" in that they can sell at 6 and buy at 4. In other words they make money. Thus the buyer and seller will engage in a transaction where before there was none.

    Now you might say, "hey nobody can create money". You are right nobody can create money. What I am saying is that the market maker gets an edge that other participants don't. The edge depends on the exchange. In my coin flip example it was pixie dust.
    But the market maker has to engage and make trades. This is their downside to getting an edge.
     
  8. Seems to be a lot of analogies here, but I will try some basic info. I was an options market maker years ago, so I am guessing things have changed some but the basic function remains the same. Each exchange has a trading floor that has many pits. Each pit has anything from a handful of underlying things they make markets in to 20 or more. A very active stock will have a lot of market makers in the pit and only a few other stocks they handle. Another pit may only have a few or even just one market maker with many illiquid stocks. It is the job of the market maker to do exactly that, make a market, that is where the bid and ask come from. The clearing firm has absolutely nothing to do with it and should not even be mentioned in the explanation. In the old days market makers had to be quick and talented because they made markets by hand, the computers weren’t doing everything back then. Now the autoquote system provides the market continuously with the market makers setting the parameters.

    If something goes crazy they will call a fast market and no longer honor the posted markets and do things by hand. There are usually a few large and important market makers in the pit who call the shots and take down large orders, surrounded by a lot of computer monkeys that just do what their handheld computers tell them to do. They all compete with each other, and usually do no like each other. With few exceptions, they are usually conceited jerks who are more than happy to screw over anyone they can. I wasn’t there, but I have heard a lot of stories about 1987 when market makers were walking off the floor to get away from the carnage and the exchange staff had to start threatening some of them to stay and make a market. That is their job, to continuously provide a bid and ask at all times. They will usually be heavier on one side, so I may have given a market but I really want to sell the offer but not really buy there, so I might only do a minimum size on the bid and sell as much as I can on the offer.

    Orders from off the floor, from retail or pros, can get matched up and trade with each other and brokers can intentionally match their orders with someone and then come to the pit and cross them but most all of the small orders are filled by the guys who stand next to each other all day. Think of the market makers as the ones who set implied vol. If more buys than sellers come in, they will raise vol, and if more sellers come in they will lower it. All market makers are doing the same basic thing, but some do large size and some do only a little, while some are always delta neutral and other take a lot of risk just like traders from home. When I was there most of my stocks were singly listed so we could do whatever we wanted and had a nice edge. Now that edge is much smaller so most market makers have gone from independents to kids working for larger firms.
     
  9. gross are you related to Bill Gross of Pimco?

    anyway...yes basically the market maker will try his best to make a double sided market buying/selling at all times knowing that they can hedge with stock/futures, etc. They collect what is known as edge, say an option is worth $5, they are willing to buy at $4 or sell at $6. If they hedge that option with the underlying, theoretically they already have a head start through expiration. They can also hedge with other options to hedge away their gamma/theta/vega risk. They basically want to stay as neutral as they can be across all their risks. Of course that isn't completely possible but they try their best. We need to have market makers because if nobody is willing to take the other side the market would be a lot less friendly than it already is (aka the market is tanking and nobody is willing to buy vice-versa). Let me know if you don't understand still...
     
  10. MTE

    MTE

    Market participants (retail, institutional and market makers) don't trade with the clearing house, they trade with each other. The clearing house comes in after the trade is made.

    Let's say that I come to the market and want to buy an option and you want to sell the exact same option at the same price. We make a trade. At the end of the day when the trades settle, rather than you and I being the counterparties to the contract, the clearing house comes in and becomes a counterparty to me and a counterparty to you. This eliminates the the credit risk for me associated with you not being able to fulfill the contract and the same applies to you.

    Now consider this, I come to the market and neither you nor anyone else wants to sell me that option then a market maker steps in and trades with me. The rest is the same as above (i.e. the clearing house becomes the counterparty to the market maker and the counterparty to me).
     
    #10     May 1, 2010