Can anyone tell me more about market makers and how they work?

Discussion in 'Trading' started by 76132, Apr 25, 2011.

  1. 76132

    76132

    I'm trying to learn about the industry and have a few questions about market makers. I'm particularly interested in exchange specialists that provide liquidity.

    I'd assume the rules are different for each exchange so if possible relate it to the CBOE but if you can't, that's fine.

    -For each security, generally how many exchange specialists are there? I guess I am wondering if normally there are multiple market makers for one option or is there usually only one official firm?

    -What are the rules for market makers when it comes to setting bid/ask prices? Do they have to give the best price or can they set any price they want? If they can set any price they want, what if they set a price too far away from the market equilibrium?

    -Since they are market makers, do they have to hold some of the assets in inventory so that they can sell if necessary? If so, how much of it do they need to have? So for example, if I make markets for options for Citi stock, do I need to have some options in inventory? Do I also need to have Citi stocks in inventory in case I decide to sell call options?

    Thanks.
     
  2. (Quote from 76132)

    Your questions seemed to be mixed. Equity (stock) market making is different from option market making. And NYSE (specialists) is different from Nasdaq (market makers).


    RE: -For each security, generally how many exchange specialists are there?

    On NYSE, only one specialist per listed stock. On Nasdaq, there can be numerous market makers for the same stock, or just 2 to 3. Depending on the popularity of the stock. More liquid, more market makers. Typically the firm (or the group of firms called "syndicate") who takes that company public (IPO) will serve as the market maker for that stock after it is traded in the open market).


    RE: I guess I am wondering if normally there are multiple market makers for one option or is there usually only one official firm?

    I am not familiar with options. But I would imagine it's multiple. For stocks: NYSE - 1. Nasdaq - many.


    RE: -What are the rules for market makers when it comes to setting bid/ask prices? Do they have to give the best price or can they set any price they want?

    Best price? Best price for whom? You gotta be kidding. They are by regulation required to "make a market". Which only means they must be willing to buy some XYZ stocks and sell some XYZ stocks. Prices are determined by the market's supply and demand. They will buy stock from you at the lowest price they need to pay and sell the stock to you at the highest price they can get away with. If a market maker really doesn't want to trade the XYZ stock on a given day, he simply posts a rediculously low bid to buy and a rediculously high ask to sell. Effectively place himself out of the market while still complying to regulations to "make" a market.

    If reality the market makers cannot bid/ask too far away from the current inside market (best bid, best ask) only because of competitions. If they don't buy XYZ at $101.50, may be a competing market maker will.



    RE: -Since they are market makers, do they have to hold some of the assets in inventory so that they can sell if necessary?

    They definitely will more or less hold some inventory. But probably not much and they must mitigate their risks (maybe with options and such).


    RE: If so, how much of it do they need to have? So for example, if I make markets for options for Citi stock, do I need to have some options in inventory? Do I also need to have Citi stocks in inventory in case I decide to sell call options?

    Option market makers hedge their risks using options, not necessarily with stocks.
     
  3. very good answer,

    for a brief moment, I limited my response, or prepared response to the world of the NYSE

    but in reality, jus about any fortunate soul that works the pits at any exchange in just about any stock / futures market,

    are market makers, provided their own capital is used to help make a market in the underlying security.....

    hope that helps
     
  4. Visaria

    Visaria

    I chuckled when i read that, sorry!

    An option market maker literally just creates an option that he sells to you, he doesn't have to have them in "inventory". It's not like a grocery shop where the seller has to have say, a banana to sell to you (assuming you want a banana!).

    Al that happens is that in his acct he is now short an option and the buyer, in their acct, is long an option.

    And no, he does not need the underlying stock in "inventory" either.
     
  5. i believe there are capital requirements to be a market maker. You might be required to have like a million dollars of equity or something.

    In options, if you are a market maker, be prepared to be holding a lot of inventory through the course of your market making. Your portfolio will end up being a basket of options. In your example you might be long the July 4 puts in Citigroup, short the July 3 calls, long Jan12 5 calls, etc. Part of your job will be to manage the risk that inventory brings. If you do it right that book of options will have very little risk. But you probably will not be running a flat book overnight.
     
  6. 76132

    76132

    Wow! Thanks for the detailed response. This is exactly what I wanted to know. Interesting how a market maker can just 'sit out' if they wanted to.

    Is there a way to rep people on these boards?
     
  7. 76132

    76132

    Thanks for the very detailed response. That exactly answers all my questions. Is there a way to rep people on these forums?

    So option market makers can just create an option to sell to you? Wouldn't that mess up the supply and demand of options because technically aren't options supposed to be tied to the underlying asset?

    I know exchange derivatives are cash settled so I guess you could create them out of thin air, but there has to be some rule to this. Using Citi again as an example: Citi has 29 billion shares outstanding. Assuming all options are traded on exchanges (no OTCs) and assuming there are only call options shouldn't the max amount of Citi options in the world be 290 million (29B/100) since each contract reflects 100 shares?

    Now obviously this is very simplified (as puts can cancel out calls) but since there is a fixed and limited amount of shares, shouldn't there be a maximum amount of options allowed in circulation?
     
  8. Fortunate enough to cough up a million dollar for a seat in NYSE. :)

    I think it is very unlikely for lone-ranger self-made traders to be market makers. Market makers are typically firms engaging in financial activities. You and I can day trade for ourselves with our $100,000 capital or whatever. It's unlikely an average individual can have the capital and equipment/office/etc to be market making.
     
  9. I think you can buy seats on the CBOE or CME for relatively cheap. And what's more the seats are assets so you can actually profit by selling them.
     
  10. (Quote from 76132)

    RE: Is there a way to rep people on these forums?

    Not on ET. Their forum software doesn't have a reputation feature. If you hang around long enough, you will have a good sense of who are giving solid comments and who the trolls are.



    RE: So option market makers can just create an option to sell to you? Wouldn't that mess up the supply and demand of options because technically aren't options supposed to be tied to the underlying asset?

    Yeah options and futures are created out of thin air. As long as there is a willing party on the other side to accept your risk transfer. Option MMs create options (sell options) because someone wants to buy them. They will then hedge their risks by doing some other options. It's all about probability contemplation.

    With individuals, naked option writing (selling options without the underlying stocks or cash to fulfill the obligation) can be very risky (to the individual, and to the brokerage firm) and most brokerage firms will not allow it unless you are very experienced and have plenty of cash to buffer potential losses. (Think about writing nake puts yesterday on NFLX through the earning release and NFLX dropped $20.)
     
    #10     Apr 26, 2011