System for backtesting

That's a good question, I would say that generally for a single order the MM would only change the specific option that was traded. For larger, more liquid stocks, it isn't one order that would change the implieds, but rather sustained order flow. This is assuming that the pricing is around some sort of fair value. MM usually have a feel for the order flow, so they won't adjust their pricing for just a couple of orders. The'll usually adjust all series when they think they might approach some imbalance in their position.

MM will trade with the book to hedge orders, and they will cut markets on orders that come in, but prices won't immediately change. Off floor traders know that MM might be looking a hedge so sometimes an order might show up cutting the market hoping that a MM will jump on it. Even if somebody is tempted, it seemed like most of those were laughed off when it was obvious what was being offered. Trading is in part a game after all.

I never traded small stocks as a MM, but it is my impression that they will be much quicker to adjust all series as a result of a single order. Some of these don't trade very often and so their spread is wide. If they adjust their prices just a nickle, they still have huge edge. So, I think you would be more likely to see an across the board adjustment in smaller stocks.

It may be a good idea if you trade fulltime to watch the tape of the active option series of the stock your trading. I don't have this right now but wish I did. It contains nuanced information which give clues as to direction as well as other stuff. I'm switching firms so I'll get this back.

 

JohnL111, I am curious, how do you “measure” the mispricings you observe, meaning how do you conclude that options are mispriced? Do you observe this in real time, or in hindsight, after the misspricings are corrected, but even then, how do you distinguish between mispriced and “correctly priced”? Perhaps you refer strictly to contracts on the same underlying of which one or more are out of whack when compared to the others?

Essentially the same question to Trajan, but you mention lunchtime.

Reason I'm asking is that I have done some serious digging on real time implied vola, which is helpful in anticipating up and down ticks but doesn’t give me any insight into possible mispricings because, especially during the first trading hour, what is the reference one would use?

Hope to hear from you guys, I am very interested to discuss this further.

 

Back in the old days of option trading, the late nineties, the most active option series in active stocks had prices adjusted manually by market makers in the crowd. If during the middle of the day the stock just drifted around, the remaining market makers may not lift an order out of the book or maybe their just lazy. It was when I was at lunch and noticing a bunch of apparent mispricing that I first realized that off floor/electronic trading was for me. I think the lunch time thing was more part of the system at the time and now, with the ISE, pricing is less reliant on human interaction. I don't notice it now, but that could be because I don't know the order flow and pricing as well.

 

My definition of “mispricing” is when the market maker is offering decent size at close to fair value. This does not occur very often! Trajan, maybe you could confirm that the only reason that the MM would give up a good chunk of his edge is when he needs to balance his book.

This brings up another question. Obviously most market makers are using black box systems to generate quotes (I read where Actant is a leading ISV in this space). So my question is: what are the inputs to the software that the MM would change during the day’s trading? Is the software so smart that the only reason the MM would override the system is if you are in illiquid/chaotic fast market conditions? Is the software smart enough to manage his book, or just a glorified calculator?

 

I've never used an autoquote system, so I hoenstly wouldn't know. I would imagine they still manage their position by person instead of allowing AI to do it. They basically adjust quotes by adjusting the IV input or by leaning a specific option by .05 or a .10.

If a MM is offering something close to fair value, understand that it's your fairvalue he's offering it at. His numbers may be totally different. And yes, he could be offering that to rebalance his position. So, it could just be a difference of opinion or his position allows him/her to offer a bunch of options at an attractive price.

edit: I should say I've never used an autoquote system hands on. Of course, I traded in pits were they were used.

 

JohnL111, appreciate your explanation but for me still remains the question: what is fair value, how do you measure it? If it is the comparison of implied volatility to some lookback historical volatility, I personally don’t attach much value to that.

I run an end-of-day options database and notice e.g implvola reduced to half of yesterday’s value with no stock movement. I analyze contracts separately and find someone selling lots of ITM puts, thereby bringing down implvola. Such occurrence might pop up on web screeners as “cheap“ options based on histvola. I myself would think twice to buy these cheap options and likely position myself against some big boy who might know more than me.

Now this is eod but it happened sometime intraday and I’m just saying, with so many factors involved it seems very difficult to determine fair value. The only objective observation of a true mispricing that I can think of would be an option that is offered below intrinsic value. But perhaps I'm just overlooking something.

Thanks Trajan for sharing some insight into floor procedures. Related to this here's a story that sheds some additional light on the MM’s world, though this one is 5 years old and may be outdated.

http://www.derivativesstrategy.com/magazine/archive/2000/0700fea1.asp

 

Thanks for the link nonprophet - very interesting article.

To be more precise, I view mispricing as a time when the MM narrows his spread significantly (e.g. from a .15-.20 to a .05) across multiple strikes of a series. This condition will not last long, we are talking minutes rather than hours. The reason why I am focused on this is because I watch intra-day implied vols on a less active ETF option series where I can figure out 99% of the time when the MMs are quoting.

It appears to me that the only time the market maker really must hedge his book with options - rather than just using the underlying for delta adjustments and collecting time premium - is when he is hit on the bid. The time decay can only be offset with a short option (e.g. if he buys calls then he sells puts and vice versa). So this is when the MM lowers his offers and keeps bids the same. Does anyone disagree?

 

I agree. Unfortunately there is little information like this out there, among an abundance on butterflies and condors etc. Any similar stories you may have or come across will be gratefully received.

Makes sense. I never played this game but just some thoughts:

I assume you also observe the cause of the MM’s reaction in lowering his offers, eg. you first see a large call sell order (trading at/near the bid) and subsequent lower put offer prices. In case not, couldn’t this be an outside order from someone playing the bid/ask spread (with puts) by first offering below the current ask hoping to cover above the MM’s bid. Admittedly though this seems unlikely if the offer goes down .10 or .15 all the way toward the bid, leaving only a 5¢ spread.

Related to my earlier post about eod analysis, if a MM’s position gets so unbalanced that he finds it necessary to hedge by lowering his offers (eg. when he bought substantial call value/negative theta) then by buying the consequent cheap puts one might be positioning oneself in line with a bearish knowledgeable investor. I’m just saying: just in case that’s the case, then that’s a good thing.

In the short run though it would seem that buying on a temporary low offer (“minutes rather than hours”) isn’t too helpful if the spread widens again while the bid just stays where it was.

I realize this has shifted towards your particular strategy and I don’t know if that’s what you want. In any case I get your point regarding the mispricings, thanks for that.

 

...hmm, unless of course you can offer above the earlier MM's offer.

 

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Derringer;
To make a long story short would agree and ;
better to aim & occasionaly trade IN THE MONEY options/underlying stock