Haha I'm as clueless as him, but luckily not a senator. Let's say I want to buy a call and the market maker sells me one. This exposes the mm to unlimited risk so would they buy another call to hedge this risk? How do option market makers avoid getting stuck with a bunch of worthless inventory at expiration?
Immediate risk with an option trade is delta, so if the mm sells 10 calls to you that have a .30 delta then he will immediately buy 300 of the underlying to be delta neutral. It is his job to manage his position to not have any of his greeks too far out of line. The best way I found to make money as a mm was to anticipate order flow. Over the years you get to know your stocks, how they react, when people tend to buy and sell, and position yourself accordingly. The mmâs only have a limited quantity of any option at a given price. If people try to buy or sell too many then the mm will change the price to find a better equilibrium. In the old days it was not that hard to make money, not easy mind you, but not truly difficult. When everything became listed on all the exchanges then it became much harder. Anyone with a reasonable amount of money can go lease a seat and be a mm, but there is as much guarantee that you will make money as a mm as you will as an off floor trader. If you are good you will make money either place, if you are not then you will end up spending your time on ET either pretending to be successful or hoping to find a way to make you so.
Once the trade has been made - and that means the buyer and seller have agreed upon a price and traded, their relationship is severed. The market maker is often one of the parties in a transaction. They establish the bid and ask pricess, although anyone can try to sell lower than the market maker's asking price or try to buy above the market maker's bid. The market maker's role is is provide liquidity - i.e., buy when no one else wants to do so and sell under the same conditions. Under more normal times, their role is to help set the market price. It's not a monopoly. They don't dictate the price, but they set the price range and anyone can trade within that range. The Options Clearing Corporation takes over after the transaction is made. They provide a guarantee that all contracts will be honored. In other words, when you buy a call, you don't have to worry that the person who sold it to you went out of business and cannot honor the contract. You are safe. You deal with your broker, who deals with the OCC. The contract is guaranteed. This is a bit of an oversimplification, but I think it answers your question. Mark http://blog.mdwoptions.com
It sounds to me that you are confusing clearing house with the exchange. That is where orders are matched with MMs being participants.
i still feel that the MM is exposed to a LOT of risk... for example if some one bot 10 puts of BIDU before result. the MM has sold 10 puts of BIDU. and he has to short the stock to be NEUTRAL correct. and then BIDU surges up.. like it did.. hence the MM is exposed to unlimited risk... how do MMs handle such situations. do they do spreads.. it still looks like black magic. !
yeah, there is risk involved but it goes with the territory and it's their job to manage that risk. Not just their delta, but their gamma too, etc. yes they will short the stock. Generally the get an exemption (or at least they used to, not sure if they still do) on naked short selling so that they can offset their risk. If they weren't allowed to do so then we'd see huge bid/ask spreads on option quotes.
Before big announcements you'll see bid/ask widen substantially (or perhaps temporarily disappear) and market makers will often charge a large premium in terms of implied vol.
MMs do not charge a large premium. That is a common misconception. The individual investor forces the large premium. When the MM offers to sell options at $1.00 and buyers take what they have to sell, the offer moves to $1.10. When buyers take the offer again, the offer rises once more. It's the absurd activity of the individual investor that pushes prices higher. They just buy and buy, never paying attention to price. Blaming the MM is foolish at best. The MM is just defending him/herself. It's normal supply and demand. Keep in mind that when everyone buys options, the MM has no good way to hedge risk, other than to get delta neutral with stock. That is not a safe way to hedge a portfolio. Thus, prices are raised. You think the higher prices are the MMs cheating the public. In reality, it's the MMs looking for people to sell options so they can reduce exposure to negative gamma positions. The only way to attract SELLERS is to bid higher for options. Thus, the public starts the demand for options and the MMs also want to buy options. Hence high prices. Mark http://blog.mdwoptions.com