Hi, This might be a Q for the former MMs... how much (if at all) does open interest affect the pricing of an option? i.e. if i'm looking at 2 similar similar strikes, but one has more OI than the other, will the higher OI have narrower spreads, and does the MM price it tighter? In particular, i'm looking at longer term options (6+ months time). I imagine MM have to balance their books on risk and that having an overly large position on one expiry might actually be a bad thing. In this case, i'm looking at the very liquid options (AAPL, SPY, etc...) thanks!
OI in all the options in a symbol and equity volume are more important. A market maker does not care if he/she is opening or closing. Just value and risk and ability to hedge. They would prefer to hedge with other options so a lot of volume on many strikes is better than one.
As an options buyer, my experience has been that higher open interest in an option usually, has a narrower spread between the bid and ask prices. Options with a lower open interest usually, has a larger bid and ask price difference. That said, there will be times when the market maker will purposely, drive down the option price by bidding very low. Example: XYZ stock, $50 Call has a bid $2.00 and ask $2.60. The market maker suddenly, drops the bid price to say $1.00 and ask is still $2.60. Now, instead, of a spread of $0.60, you have a spread of $1.60. In those cases, it would be hard to get a decent fill whether you are buying or selling.
OI doesn't mean a ton. Where it can have real meaning is on a low OI, single list exit. It's the roach motel joke.
Delta is hedged with the underlying (or futures) as you say. However, sooner or later the book will be leaning too much in the convexity Greeks - like too long gamma, long vega etc. The MM would usually hedge that by skewing his markets towards the risk he wants to cover. An overly large position in a single option can be an actual problem should you get pinned on expiration, so they usually to spread that risk around.
SLE said it better than I could, as usual. In addition, there is only so much you can learn in books about derivatives. Practical experiance is a better learning tool after you get the basics. 25 years ago, most MM were locals. Around 2003 that started to change with multiple listing and automation. Today, most local MM like me are gone. Today, they all work for medium to large size firms. The larger MM are almost all automated and many use a global dispersion strategy. They not only monitor single stock risk but their portfolio risk. They would prefer to trade a lot of options on many strikes, both long and short on many related symbols that are correlated or vs a correlated index. My view, as I traded, and the view of a retail trader is just not the way they look at the market. They could care less about a 100 lot 1 second after the trade, unless it was follow up with many similar orders which will move their values. It is not done manually at most firms.
Your example has happened to me (on very tight spreads originally), and I find it doesn't matter how large the OI is. It will usually spring back to a more "normal" spread within a day or so, at the most. That being said, I still want an OI of a least 10,000 with a nice tight spread of < .05. Starting with a .60 spread is a massive hurdle to climb, IMO.
my observations with spreads like these, is that they will tighten throughout the day. by the last couple of hours, they are tighter and more 'normal'.
At times it does not move at all. Market maker probably, low balling and trying to grab options from desperate retail traders. The very next day, when they are selling, they will raise prices up. That is the time to get out if you are trying to sell your position. I don't bother when I see this price manipulation knowing tomorrow it will be much, much higher!