brokerboy are you always this funny ? or does it get any better ?? do you know the answer to the question ?
so, why do you ask when your name is optionPRO? j/k. Read up on dynamic hedging. Delta, gamma, theta, etc.
Do you know of a book that covers MM hedging in reference to option trades ? If there is a book please let me know I need to read it. I am not asking about delta or gamma hedging from a retail trader's perpespective btw. I am a net buyer and want to know what the other party, the market maker is going to do to hedge his position, and how it can affect the price of the stock if I am doing a big purchase. I figure that at one point it will be them against me, and knowing your enemy is half the battle. Implicitly they will run the stock against me to try to shake me out based on the size of my position. Or do they sell puts in another stock ? And I have not a worry ? I don't think it is such a difficult question I hope. Any advice will be very appreciated. Thanks.
The MM would be buying stock to flatten their delta, as selling stock would increase their exposure. A trade in ATM options would result in the MM buying 50[50k shares] deltas in stock, replicating a short, synthetic ATM straddle. Hedging smaller gammas in ITM/OTM options results in taking greater spot/gamma risk for the MM as his static-gamma position is smaller, but contains upside-gamma risk[convexity-risk]. IOW, the MM will be more inclined to replicate/lay-off his gamma in buying options into the upside-gamma risk of the ITM/OTM position, while the ATM position allows the MM some time to shop for wings to purchase. In either case the motivation is to reduce risk through the immediate purchase, natural or synthetic, of the underlying shares.
Riskarb: I have read previous posts from you, and I must admit you are by far the most knowledgeable person in the subject of options in this forum. I figured you would be the only one who would really know the answer. I want to congratulate you on your experience and your generosity of mind. This is what I understand, if I buy 1K calls, MM buys the equivalent in shares, if I buy puts, MM shorts the equivalent. It would appear that my purchase would in itself help me since the shares would move in my direction to start with ? Am I to expect the MM to try to wiggle me out of the position, once it is established? Or am I being paranoid ? Thank you very much for your help !
you are being paranoid. There are many types of market makers. Odds are if you do that kind of size, there isn't one MM on the other side of the trade. Some may hedge the delta directly with stock, some may hedge it by spreading out, some may hedge it with a number of correlated products. furthermore, the big MM's are trading millions of contracts per day. the 1000 lot you trade is just another piece of the puzzle. one more thing: it makes a great difference if you are talking about a stock with average daily volume of 100K shares or a couple of million shares. ditto for volume and liquidity in the stock option class you're trading.
an addition to the above post: A lot of the MM's are not independent solo operators but trade for a firm, they may make markets on several names and their trades are fed in their mother computer. There are people upstairs monitoring the combined position to make sure that the firm's exposure is not too lopsided. If the MM by any chance could or did not hedge their side of the trade after filling your order the upstairs people may hedge it in the process of costantly working on the global hedge. Also think of the MM as a person keeping 7 plates swirling up in the air. While the are definitely working to have an edge and make money they are too busy for intricate games on each order. When you are submitting an order on a slow option chain it does not mean that they are asleep at the other end because they probably handle many other names. As far as buying on the bid and selling on the offer, even if you were personally standing there you could not do it unless you vere experienced and agressive so don't even dream about it from upstairs.
I used a simplistic example of a single individual making a market in 1000 calls. Obviously that's not likely to be the outcome of a similar event on the post of XYZ options. There isn't likely to be a waiting conversion/box/roll available, and selling 1000p simply doubles the size of the straddle from 500 to 1000[synthetic/natural]. As has been stated; the DPMs are often large firms represented by individuals who simply fill the paper and the d/g/v risk is handled upstairs. Often resulting in additional, proprietary order flow being sent to the pit in which your 1000 calls were traded. Firms like these are always looking for arbs, but will often replicate in correlated markets.