They could do a couple of things. The most likely would be to trade stock delta neutral. Also, they could trade with an order sitting in the book. They would look for a hedge which would lose the least amount of edge that they just gained(no brainer!!). The preferred choice would be trade options against options. Stock is an imperfect hedge because it only reduce risk in a postions delta exposure. MM need to analyze their risk in all the greeks. An in the money call has different characteristics than an otm. So you would try find an option which demonstrates similar greeks. This goes to the heart of my point earlier. The 80 call shares little with the 65. They are disimilar options. The 65 still has substantial greeks to factor in risk control and will until expiration as long as it is atm. The 80's greeks are rapidly approaching 0 if they aren't already there.
interesting input guys. After thinking about this for a while, I've come to the conclusion that even if the specialists understand the flaws of the pricing model, well... they also have to deal with it just like we do, and they're certainly not immune to inefficiencies. It's my hunch that the second they understand what you're trying to do and intuitively know that you may very well be right they immediately do what they have to- which is, like trajan said, trade the stock delta neutral or hedge with options with similar contra deltas. Perhaps right upon buying the 65 call in the Brl trade (and immediately taking on the heat) they would turn around and buy the 65 put to try and get as neutral as possible. I don't see how they could refuse to sell you a far otm 80 call, almost a sure thing premium, albeit tiny for them. The 80 call wouldn't cause them much worry because all the greeks there are pretty insignificant. So their awareness of the flaw in the 'drunkard' model doesn't mean that they would refuse you a trade. They can't. They have to take the order flow and hedge as soon as they can. So maybe the implications of this are quite interestingerhaps we shouldn't worry about option specialists saying no to trades just because they are high probability ones. While they can buy on bid and sell on offer, they also cannot forsee the future, and in my view mostly react as fast as they can when faced with good traders' orders. One caveat: when it comes to gaps and event driven surprises in the stock, (earnings, FDA announcements etc) then those fellas definitely jack up vols as an extra 'hedge' against uncertainty. In my view no amount of delta neutral hedging is of much help against the mighty gap down or gap up... only way out is to make those suckers pay as much as they can for that premium... which in turn, creates opportunities in vol skews.
Found this on Mcmillan's site. He gives us the lowdown on specialist thinking and trading- Question: Let's take an example from one of your recommendations. Suppose you are the type of trader who has the psychological and financial ability to sell the naked S&P May 1125 puts. SOMEONE has to buy them from you. What if the MM can't find a buyer? They would have to buy them from you. Since they are not dumb and know the position will likely expire worthless, wouldn't they be forcing themselves to buy a losing position? The same could be said if one is long a deep in the money option. You decide to sell near expiration day. Who would want to buy an expensive option like that? Answer: Market makers don't get a choice -- they can't go looking for a buyer. THEY MUST PROVIDE the market -- that's what a market maker does. He can't just take trades he thinks are good trades. Market makers rarely hold positions for more than a few minutes or hours at most without disposing of them or hedging them. He carries a whole portfolio of options, so the puts he bought would be added to his "portfolio", contributing its share of delta, vega, gamma, and so forth, which he would hedge with other option transactions or with the underlying itself. You can always trade the underlying and exercise your option. The market maker can do the same thing, so he will always provide a bid that is within a fraction of a point of parity. For example, suppose you are long a May 50 call, expiring tomorrow. The stock is trading at 80. The option is "worth" 30. The market makers will generally bid 29-3/4 or more, because they can make a free 1/4 of a point if you sell the option to them at 29-3/4 (they buy the call, sell the stock at 80, and exercise). If, for some reason they are not making a reasonable bid, you can do the same thing yourself -- although you will have to pay commission. So instead of selling your calls to them, you could sell the stock at 80, exercise your calls at 50, and pocket $30 less the commissions as the "equivalent" sales price of the calls. I have a feeling that you think these markets are sort of vague, where the market makers only take trades that YOU would take. Do you feel the same way about the specialists on the NYSE? I doubt it. Option market makers and option specialists provide the same function -- they maintain a fair and orderly market by buying and selling for their own account, taking the opposite side of trades that customers enter. EVERY option has a market and that market is "good" when someone wants to trade it -- the market maker can't change his mind because he "knows it will be a losing trade". In fact, he doesn't even view them as trades -- just another chance to buy on the bid and sell on the offer, or to hedge his position if he can't do that.
Yes. A significant part of the volatility explosion that happens on those very nasty down days is the result of the MMs jacking up the vols because of their desire to reduce their market exposure. I've ended a day like that buying more premium than selling. The stock itself did not justify an increased vol as it was fairly quiet. The crash of 1987 still haunts many people. You just can't be sure when the selling will stop. They most likely have been selling premium in the preceding days and are getting near their limits. If they didn't raise volatility during market turmoil, even if the stock was not very volatile, it would most likely attract buyers of premium who would be arbing across markets. What we have not discussed much is the supply/demand part of option prices. Vol explosions happen as a result the imbalance between buyers and sellers. MMs are not limitless wells of option premium. Vols will rise to a point where there is a balance. As I said above, the best hedge is another option. During a normal market, MM will be patient to hedge their position with another option. Stock will do. During crazy markets, MMs want to be damn sure premium sellers are around. Of course, the huge premiums help with risk management and the P/L.
Trajan: Man, it really takes cojones of steel to be a market maker. although lots of people like bashing the specialist for all their problems, I feel that those who step up to the floor really show amazing courage and determination. You're right, we didn't discuss much supply and demand. That's the bottom line I guess. If everyone and their grandma are selling their calls in a crash or covering their short puts then there's only so far a mm can go in absorbing all that, deep pockets yeah, but like you said, certainly not inexhaustible. And if after buying up the truckloads that everyone's dumping the mms can't find anyone to sell to over the next sessions, then that could be the end of the game. As I suppose it was for most of them in 87. I've always wondered about the black friday crash. Of those who were still standing when the smoke cleared, what factors helped them in their survival? was it mostly luck in the sense that they were dealing in stocks that were relatively less hit than others? or was it that they were relatively less short puts/long calls/bullish than others?
I don't know how people survived that day as I was still in high school. The current haircut(this is different than what is commonly refered to on these boards. It is very similar to margin.) requirements are to have enough capital to cover a 20% move up or down and a 50% drop down. If a traders stock moves less than that, and makes no trades to offset risk, he would still have to contend with the volatility explosion. Naturally, if he was long premium to the downside, he wins. A guy from the Pcoast was in Tibet or some other country when the crash occured. He hurried back to discover he was a millionaire. In Amsterdam, tax laws are such that leaving excess capital in your account reduces overall tax burden. For that market, traders were able to absorb losses because they were very well capitalised due to tax incentives. In America, traders try and reduce their credit exposure. Clearing firms do blow up! It is a generally held belief that you do not leave excess capital in your trading account. This is true wether you are an independent or with a large firm. Large firms blow up as well. I think it was Wolverine that nearly blew up during QCOM's explosion from 200 to 800. My problem with the McMillian quote is that you do have a choice. It is quite easy to walk off the floor. When Amazon started to go nuts in the spring of 1998, the MMs just left the crowd. There was nobody there to make markets. They made an announcement calling for MMs to the Amazon pit. Some guy walked over there and made a ton of money. Also, you don't have to trade 50 or 100 contracts. Just trade a 5 lot(assuming the crowd fullfills the exchange requiremnt) and move the market. Your not there to take one for the market. I think he was being a little to rah rah. The most difficult thing is that you have to make a decision very quickly, literally seconds. You get good at it. An off floor person can run an analysis to determine if a trade is good or bad. On the floor, you do it in your head. Typically, you have a game plan as to how you want to shape your position. You adjust your markets to take into consideration your exposure.
Trajan: Out of curiosity, during the big bull market where many equities(ala Amazon) went straight up and never pulled back, did alot of individual mm's or mm groups "warehouse" positions to make markets in these stocks? It would be hard for me to believe that some of these larger mm groups(ala Wolverine Trading) were making directional bets on some of these tech stocks and selling calls, etc without warehousing a position to trade against. From my experience and understanding of alot of these mm groups, they are all basically running computer models in their upstairs office and then sending alot of 23-24 year olds down to the floor to basically bid/offer the sheets...It would be hard for me to believe that big well-capitalized firms could be caught like that... Look forward to your observations...
This is my third reply to your question. Each of the previous posts were erased due to my foot hitting the power cord. Hopefully, it is better than both. I would say overall that many of the people trading the tech stocks going straight up were making money. What happens is they jack up volatility so high that sellers of premium enter the market. You end up having two way order flow. It is not just CS orders taking premium from the crowd. Plus, nearly everyone with a profit sells there options at one time or another. MMs made a lot of money in AOL as it went up through the roof. The volitility was enormous but so were the volumes in the options. People started losing money when the stock topped out and volitilies came down as the stock went down. They got stuck with a lot of very expensive premium. It doesn't always work out that way. Sometimes the option paper is entirely one way. You may be unable to borrow stock to sell short. This stuff happens. Like in the previous Amazon example, the people trading it were unable to handle it, so they left. It was the right decision for them. Somebody else stepped in to make markets. About your question of warehousing, yes MMs do "werehouse positions. An example of this would be the anticipation of an earnings release. MMs will horde option premium of months with earnings announcements. A couple a of days before the announcement, speculators come in to make bets on how the stock will react. Volatilties start to rise. You sell out your inventory and start getting short premium. Earnings come out, the stock makes its move, you make a bunch of money when volatility gets crushed the next morning. Every trade a MMs make goes into their position. With one exception being way otm long calls, it is all managed a giant dynamic beast. A MM would't sell a hundred calls and leave them out thinking they want to take a gamble on them. However, every time I make such a statement there is some story out there that is an exception. I will post one of my old positions in IBM to illustrate what it looks like to a MM. I had originally done this on Saturday and nearly finished when my foot destroyed my work. Look for it later tonight.
Guys, Thanks for all your thoughts and comments. This has been a really good thread and I've picked up a few helpful insights along the way. If anyone wants to talk about option strategies l'd be glad to contribute more.