questions for real MMs: options Market makers delta and gamma hedging

Discussion in 'Options' started by scriabinop23, Mar 9, 2007.

  1. i understand how a options market maker maintains gamma and delta neutrality thoughout the day (buying and selling hedging stock and options). these questions are directed towards professionals CURRENTLY in the business or aware of how it works, especially w/ automated and electronic trading models. not looking for an outdated book that explains how market makers hedged positions 15 yrs ago.

    but overnight gap risk would make it very difficult for an options market maker (I'd imagine) leaving positions open as a big overnight move would significantly change his net gamma and net delta position.

    so 1:

    how does the options market maker even profit if he must buy so much stock and options at potentially disadvantageous prices in order to keep hedged? [is it all in volume on a few cents spreads?]


    on a gigantic book, which for example on many stocks, implies retail as net long lots of options and MM short positions (initially), how does this huge imbalance affect MMs in their ability to hedge at appropriate prices?

    i assume in oversimplified manner if someone buys 10 deep otm calls at a net delta of 100, the MM maintains 100 shares (or closer itm calls of equal delta) and 2 atm 50 delta puts to hedge the position. As the position moves against the MM, he may buy more calls or stock to hedge the position. Likewise I assume an MM may be net short plenty of puts from the same retail public, so often his call sales result in him closing his short put positions to properly hedge. Correct?


    But despite all of this, how does an options MM not get whacked when despite ending the day delta neutral, a buyout occurs and a huge gap happens ?? gamma neutrality could solve this, but I'd imagine its almost impossible to stay continually gamma and delta neutral without losing money (since all the hedging activity would most likely result in loss of edge). True? Or is this hedging and potentially gap loss offset by maintaining a large inventory to always pull hedges from, and by being statistically usually short theta?


    question of internals: on a stock like AAPL or GOOG, how many market makers are there? and are they entirely computer automated or is there a manual human component.


    are MMs ever generally exposed to being terribly long theta, where the public and retail market are generally net sellers of premium? What situation does this create?


    any statistics available on how much options activity on heavily traded stocks is not between public and MMs, and directly between two entities excluding the MM? (i assume this occurs more heavily traded stocks that have huge volumes on both sides) Interested, since I'd assume heavy open interests where MMs aren't one side would result in less hedging activity on behalf of the holders of their positions. Good assumption?
  2. cvds16


    Seems like you know something but not really too much details about what mm do. You are furthermore assuming a lot in your questions without really stating it, for one you are talking about gamma short positions if I read this clearly, otherwise there would be no problems with the situations you describe. Also a mm will try to avoid 'taking' prices in options, but will prefer to keep on 'making' them, he will rather trade stocks to hedge his positions. A mm will try to keep every greek low in general and will adjust prices and hedge accordingly trying to trade options with an edge and using at market prices in stocks. When his overall position gets out of line a mm (for example too much short gamma) will adjust his theoretical prices (going up so that he becomes a first bid and his offers are going higher). A market maker thinks in terms of volatility and of the eb and flow of orders that comes his way. Every time he gets hit the mm has a (small) edge which he has to lay off somewhere. It doesn't work the way you describe it at all. It takes a while to understand it, but it's not exactly rocket science either.

  3. so basically is it fair to say a MM typically maintains his deltas during the day solely with stock, and near end of day typically tries to get all the greeks neutral by purchasing or offloading options and stock to offset gap risk, figuring he'll make more than enough on his edge (being hit on his ask or bid) to offset any hedging costs over time?

    now is this all automated nowadays?
  4. cvds16


    no, a mm typically tries to get neutral in his delta always immediately but will adjust his prices (upwards) if he becomes too short in gamma for example. It's not a one step, two step kind (like at the end of the day) of thing, it's a continuous process.
  5. my point being that since gamma isn't addressable with stock, that an MM has to be able to offset gamma w/ options ... which means besides increasing his premium to offset hedging costs, MMs often aren't too lopsided in their exposure.

    lets go with a simplistic example. lets say the public only buys plenty of deep OTM calls from the MM and there is no other open interest. It wouldn't seem to make much sense to hedge with stock if the MM is this lopsided in his exposure, since then he would be net short so much gamma. Obviously he'd be able to up his selling premium on the OTM calls to help offset his hedging costs. But how would he get gamma neutral? would he just buy closer to the strike calls to equalize gamma?

    ie, MM on goog sells 200k 550 OTM calls to one big buyer. Besides asking more, what would the MM likely do to eliminate his exposure to this trade? Or does he often take a loss with big purchases like this (in order to stay neutral).
  6. The MM will evaluate the risk and act accordingly. Let's say that the MM did not have a position beforehand, then the MM will try to hedge the upside risk. The simpliest hedge would be to adjust the MM's theoretical values of "similar" options upwards and would try to be a buyer of "similar" options to reduce the position (mainly reduce vega/gamma risks).

    The MM would want a large enough edge to take on the risk and hopefully, would make money even after adjusting.

    Your other ideas regarding MM's hedging of risk is correct on the conceptual level, but it is implemented in a much different manner in today's world.
  7. 1. If the MM is buying/selling at bad prices the MM will be gone. MMs wouldn't quote prices that do not have enough edge to be profitable. If trading correctly, MMs trade at Advantageous prices so MMs will make money. Retail trades at Disadvantageous prices.
    2. Being short calls and short puts do not close out your position. You are net short options and short all the greeks/risks associated with them. You are not flat.
    3. MMs take on risk for an edge, at the end of the day, hopefully that edge can counterbalance certain market events. It's all about managing risk/risk scenarios
    4. 30-45 MMs in large stock options, some by pure computer algorithms, some by only humans... but most somewhere in between.
    5. Not necessarily. But MMs are risk adverse and will require greater compensation if all are receiving theta.