Hey, Let's say you have a completely hedged position or no position at all. Also, let's say you make markets for a very liquid market such as options on SPX or VIX. Then, the market opens and someone makes a trade against your spread so you are net long/short calls/puts. Few Questions: 1) What is the target time when it comes to how long it takes to hedge your position and lock in a profit? In other words, how much time should it take to hedge your position? And how much time should it take to lock in a profit? 2) In practice, in general how long does it take for you to hedge your position and how long does it take to lock in your profit? 3) What is the longest time it took for you to lock in a profit? Thanks!
Here is the typical way it works with an instrument like the SPX. After a trade is made, the MM will immediately trade the appropriate number of S&P futures to hedge the position, the goal being to make the trade delta neutral. Depending on the size of the trade, the MM will lower or raise the values of his options. He will want more "edge" to make a similar trade. There is rarely a "locking in" of profit. To truly lock in profit, he would have to do another trade and essentially be a customer giving up edge. Eventually the MM will reach his uncomfort zone and try to reduce a long/short premium position he as been acquiring and end up losing money. The hope being that there is enough 2 way paper to keep this from happening or the MM is correct in attempting to be long/short premium.
Before we get into the whole "how long and how much" thing, you gotta realize that there are two separate types of MMs - there are automated market maker and institutional market makers. The differences between these two models are huge and, for practical purposes, these are different businesses. AMMs, in general, deal in small(ish) size and most of their P&L is made in bid/offer spread. Of course, every AMM book runner will be telling you that "at least [insert your favorite number between 50% and 100%] of my P&L is alpha" but as one could observe, the amount of risk they carry overnight is usually tiny, even accounting for the basis risk. Also, they rely heavily on real time low latency execution. While you can't cover risk on specific strikes, if you have enough flow, you can cover in a different strike or a different expiry and run a net flattish book. If you are running a large AMM business, the diversification effect kicks in sooner or later. Institutional business (like the desk i am running) is geared toward dealing with hedgies, pension funds and insurance companies. The sizes here are varied and could be pretty large - it's not uncommon for me, for example, to take down a trade worth a few million dollars of vega. Here, most of the money is made on smart book positioning. In fact, it's fair to say that most of the competitive business trades at mid or worse - a hedge fund or an insurance company will put 4-5 banks in competition and trade at the best price. The business model most people have adopted is to price trades at mid if they like the risk and price them to lose if they don't like it. Now to your questions. Pretty much every trade would be delta-hedged from the start - either the client is quoting it vs futures and we exchange delta with the counter-party or, if quoted live, the trader would execute delta ASAP (usually we would delta adjust the option price in that case). Some times the desk would execute vega/gamma hedges at the time of the trade and sometimes I'd be holding on to the risk for weeks and even months. Did I confuse you further or is it clearer now?
Your looking at the marketing maker business in too narrow a scope. Being an options MM is like being a bookie. You make lots of bets based on your current evaluation of the odd of success. You constantly reprice your spreads to market conditions based on bets made before. You are constantly hedging your bets looking to make a vig on every trade. A MM does not look at individual trades, but their position in total. Their risk in total. Their P & L in total. It's a fluid process that goes from open to close. Individual trades disappear into the total position like drops of water into a glass. Bob
I really appreciate the responses. I've never worked in the industry so my posts may seem kind of naive, but I am very interested in learning more. My questions are bolded in the quotes.
re:"Before we get into the whole "how long and how much" thing, you gotta realize that there are two separate types of MMs - there are automated market maker and institutional market makers. The differences between these two models are huge and, for practical purposes, these are different businesses." SLE to clarfiy: are you calling the MM at the CBOE(or other exchanges) the AMM(automated)?
I think my posting rights are still restricted so my earlier post may be confusing as I didn't get a chance to edit it.