Why would option market maker do this trade?

Discussion in 'Options' started by marcchen, Dec 23, 2008.

  1. marcchen



    I am trying to understand why Option Market Makers would be willing to do the following trade:
    SRS is trading at $57.3/shr
    SRS Jul 2009 $320 PUT is Bidding at $262.10 and asking at $265.40 with zero open interest
    I sell this option for $263.5, and SRS rises and stays above $57.3
    then I made money on this trade.

    Because there is zero open interest, I assume only Market Maker is filling the order.
    If this trade is executed, I immediately receive $26350 in my account, minus commission.

    How is the market maker able to do this trade and make money?

    Thank you very much for any information.

  2. I don't believe you will be able to sell the put for that price. No one would pay it.

    The reason there is zero open interest is that every single option that has been owned has been exercised.

    The market maker makes money by buying the put option under parity. That means he buys the put and buys stock. He does that ONLY when he can buy both for less than $320. then he exercises the put immediately and keeps the difference between 320 and the amount he paid - less his commissions.

    If he cannot buy the combination for less than 320, he will not buy your put.

    Unless this is a theoretical question, why are you interested in selling this put? You will be assigned overnight and own the shares. Save yourself some expenses and simply buy stock.

  3. What makes you think the MM will give you 263.5 when he is only bidding 262.10?

    BTW, I sense that the 262.10 bid is somehow incorrect although I didn't really do any investigation.

  4. marcchen


    Thanks for the responses.

    I probably used a poor example.

    The reason I ask is that I have been able to do similar trades, just not on this security.
    Some are near money, some are out of money, some are deep in money.
    Of course, I had $4-5 of paper profit when I sold the puts, because the premium paid and stock price guarantee I would not be assigned immediately.

    My main interest is in understanding how market maker makes money in these cases where there is zero open interest and they buy a put from me.

  5. My understanding is that MM's generally make money on the B/A spread. Ideally the MM would like to sell and buy equal quantities and thereby simply pocket the spread.

    If there is a big imbalance between buys and sells, the MM adjusts the B/A accordingly. That is, too many sellers causes the B/A price to go lower, vice versa for too many buyers. This price adjustment helps the MM obtain equal buys and sells.

    If the MM still has an imbalance my understanding is that they can delta hedge my buying or selling the underlying stock.

    In your example, where there is no open interest, I assume the MM would delta hedge. However they would probably aggregate the deltas across all Strikes.

    I'm not really that savvy on how MM's make money. Hopefully the above is generally correct. If not, maybe someone else can offer a correction or a better explanation.

  6. They buy any option from you because they have a chance to hedge that option in such a way that they have a theoretical advantage. Not a guarantee of profits, but an edge.

    When you choose do sell a DITM put, the best hedge is to buy stock, exercise the put you sold under parity, and take the profit at once.