option market makers and delta hedging activity in illiquid equities

when an options market maker writes a call option in a liquid stock, it would seem to be no problem to offset their delta exposure by buying the underlying (and since liquid equity spreads are most likely smaller than the associated option spreads, the writer may make arb profit as well).

but what is the analogous hedge for an relatively illiquid equity (or a stock with alternating periods of high and low liquidity)? If a market maker is filled for a large call option order, offsetting their delta exposure by buying the stock could result in a large price increase in the underlying, thus destroying the effectiveness of the hedge.

so what do writers do in this situation? one could buy enough puts to offset the delta, but illiquid underlying leads to high option spreads, making this a potentially costly route. or do high option spreads mean any option writer has some leeway to offset their exposure before the write becomes unprofitable?

any help would be much appreciated

 

1) That's the reason why bid-ask spreads become larger with less volume for illiquid stocks and their options. If you feel like giving away money and liquidity for free, you can clamp down on the spread and post larger size.
2) Larger orders can be absorbed over multiple prices where you "compel" the customer to keep "reaching" for additional size in order to fill the trade.
3) Keep in mind that customers may have inside information that you don't know about. There's no shortage of people who are willing to "jam" you with a losing trade.

 

When dealing with highly illiquid names, you should buy the stock first and lean on the option order. When you have gotten filled on your stock, then you can put your option order out.

The risk, of course, is that the options get traded while you get your stock. But most likely, the call writers would then rush out to buy stock, thus driving up the price. And you can get get out of your stock during this period.

 

A market maker in the options would have an idea of how much stock was out there in the stock before he made a size up market in an option. Don’t forget options mm’s are not walking around the floor saying I’d like to do some covered calls on this stock and buy some puts over here and so on. They usually have a reasonable handle on the books they’re signed into. In addition there are few “locals” really left, and most markets are electronically disseminated with the residual positions managed off site. In order for someone to execute a large order in a stock and option that’s got vague liquidity they’d have to work something or chase the price.

 

if you're making a market and end up in a large postive delta for example. you can offset with being better offers and better bids for calls and puts respectively. you dont need to go and hedge with underlying right away.

 

Market Makers are generally not in the business of taking directional specs. In addition they’re not in the business of letting the order flow hand them directional specs. If they do want a delta, positive or negative they’d take it themselves. That being the case they’re not likely to hang onto any delta given them by the order flow.

As far has a hedge, as I mentioned earlier most of the position management is handled off site and is usually part of a larger dispersion matrix. Therefore the firms manager who is looking at the risk from off the floor of that market maker would decide how to tackle that delta. If it’s an illiquid issue as you mentioned they’re probably not going to adjust their options bids and offers and hope someone comes in and hands them the opposite delta. They’re likely to hedge with the underlying or a similar issue.