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Who Are Market Makers?
Who exactly is buying the options I sell?
Who exactly am I selling my options to?
Indeed, alot of people think that in options trading, they are actually buying and selling options with another options trader just like themselves in the open market but that is not always true. Most of the time, you are actually trading with a professional called "Market Maker" instead of another regular options trader trading from their computers just like you are.
Many option traders and stock traders ask, who is buying from me when I am selling and who is selling to me when I am buying? What happens when nobody wants to buy a stock or stock option which I am selling? In a normal, liquid market, there are usually someone queuing to sell a stock or stock option when you are buying and someone queuing to buy when you are selling. However, there are times when nobody is queuing to sell when you are buyng and times when nobody is queuing to buy when you are selling, so, how is it that you are still able to buy or sell your stocks or stock options smoothly? This is where Market Makers come in.
A "Market Maker" can be an individual or representatives of a firm whose function is to aid in the making of a market in an options exchange, by making bids and offers for his account in the absence of public buy or sell orders in order to ensure market transactions are as smooth and continuous as possible. When an option trader places an order to buy a stock option which nobody is queuing to sell, market makers sell that stock option to that option trader from their own portfolio or reserve of that particular stock option. When an option trader places an order to sell a stock option which nobody is queuing to buy, market makers buy that stock option from that option trader and adds it to their own portfolio and reserve. In doing so, market orders are continuously moving, eradicating sudden surges and ditches due to buying and selling imbalance.
You'll most often hear about market makers in the context of the NASDAQ or other "over the counter" (OTC) markets. In contrast to the "Specialist" system that the NYSE employs, NASDAQ has no individuals through which a stock's transaction must pass. Instead, all transactions pass from one market maker to another. In the market maker system, market makers compete with one another to buy or sell stocks & options to investors by displaying quotes and are obligated to buy and sell at their displayed bids and offers. An investor may be dealing with several market makers at once if that investor is placing a very large order which cannot be filled by the inventory of one market maker. An option trader may also deal directly with individual, specific market makers through Level II Quotes.
In reality, Market Makers make up the actual "market". When a stock or option trader places an order with a broker, that broker fills that order by buying or selling with the Market Makers.
Another way of understanding what Market Makers do is that Market Makers are like the book makers in Las Vegas who set the odds and then accomodate individual gamblers who select which side of the bet they want. A Market Maker supplies a bid and ask price and then let the public decide whether to buy or sell at those prices. As an options trader, Market Makers are master position traders who aims to establish and profit from every low risk and risk free opportunities.
Advantage Of The Market Maker System
In NYSE, there is one official employee of the exchange to act as market maker for each security. In the Market Maker System, many market makers are assigned to every security. As every Market Maker effectively acts as a "Specialist" like in NYSE, there are effectively many specialists for each stock. This creates a decentralised market place where liquidity and volatility varies. This improves overall liquity and makes market manipulation much more difficult.
What Happens If There Are No Market Makers?
Market makers have given option traders quite a negative impression as people who buys at very low prices and sells at very high prices just when an option trader is desperate to buy or sell a position. Let's see what happens when we remove market makers from the markets.
XYZ stock is an extremely bullish stock who has just announced fantastic earnings. You want to buy XYZ stocks but investors who are already holding XYZ stocks are not selling. In order to attract a seller, you begin to bid higher and higher for XYZ stock until at last, a seller is moved to selling the stock. This price could already be extremely high.
Consider again a sudden bad news released from XYZ company, creating a rush to sell XYZ stocks. You are queing to sell but nobody is buying. In order to attract a buyer, you start to push the price lower and lower until at last, the price bottoms out worthless.
As we have seen, in an imbalanced buying and selling situation, market makers play an extremely important role of creating liquidity for prices in between in order to eradicate huge gap ups and downs and to ensure a liquid market for all.
How Does Market Makers Make A Profit?
Market Makers are not paid commissions to buy and sell stock options, so how do they make a profit? Well, most institutional market makers simply earns a salary from the marker maker firm that they represent. Market Maker firms like Goldman Sachs and Morgan Stanley, commit their own capital to maintain an inventory of stocks and options and represent customer orders. On the trading floor, Market Makers make money by maintaining a difference between the price he would buy and the price he would sell a particular stock or stock option. This difference in price is known as the Bid-Ask Spread. A bid-ask spread ensures that if an order to buy and an order to sell arrives simulataneously, the Market Maker makes the difference in Bid-Ask Spread as profit.
Example : XYZ May30Call option has a bid price of $1.10 and an ask price of $1.30. Market Maker John recieves simulataneously an order to buy and an order to sell. Market Maker John buys that May30Call option from the seller for $1.10 and then sells that same May30Call option to the buyer for $1.30, thus making $0.20 in profit completely risk-free.
However, when a Market Maker is not confident that a stock or stock option can be so quickly bought and sold, due to the fact that there are only very few option traders or stock traders trading that security, then there is a risk that a stock or stock option which that Market Maker buys can only be sold when the market price is lower than the prevailing price, therefore resulting in a loss. In order to protect against such a risk, Market Makers, widen the bid-ask spread so that the transaction remains risk free to him over a larger price range.
Conversely, when Market Makers are selling highly active option contracts, they frequently raise the price of the option through increasing the implied volatility of that particular option contract. That results in the Volatility Smile or Volatility Skew.
Apart from market making, market makers also make profits from options arbitrage. An arbitrage opportunity presents itself when a severe deviation from Put Call Parity occurs leading to options pricing discrepancies which can be locked in completely risk-free using options trading strategies such as the Box Spread and the Conversion & Reversal Arbitrage. As any possible profits from arbitrage is extremely low, only Market Makers who need not pay a broker commission can actually make any money out of it.
How Does Market Makers Protect From Risk?
As you can see by now, Market Makers are like you and me, buying and selling stocks and stock options. Doesn't that expose them to certain directional risks? Yes, even though market makers endeavour to be able to buy and sell simultaneously in order to benefit risk-free from bid-ask spread, such ideal situation rarely exist in stocks or stock options which are not extremely liquid. Most of the time, Market Makers end up owning stocks or stock options and that exposed them to directional risk.
Example : Market Maker John buys XYZ May30Call option from a seller for $0.80. If XYZ stock falls before Market Maker John manages to find a buyer for it, Market Maker John stands to lose money as the call option decreases in price.
Market Makers protect themselves from directional risks through "Hedging" and flexible use of synthetic positions. A Market Maker hedges his inventory through buying or selling additional stocks or stock options in order to achieve a position whereby stocks and options falls as much as the other rises in order to maintain the overall value of the account. This is what we call a "Delta-Neutral" position. A Market Maker's positioning strategy, especially in making markets for stock options, is extremely complex and requires to the second calculation and execution. It is because of this complexity in balancing all kinds of risks that some new Market Makers actually lose money to the market despite all the privileges of being a Market Maker.
Risks That Market Makers Face
Market Makers for stock options trading faces 6 forms of risks which, in fact, all option traders face :
1. Directional Risk / Delta Risk
Directional or Delta risk is the risk that a stock option price will turn against the market maker as the underlying stock value changes. A Market Maker consistent attempts to hedge this risk by going "Delta-Neutral".
2. Gamma Risk
Gamma risk is the risk that the delta value of a stock option may change over time. This consistently threatens to tip a Market Maker's sensitive Delta-Neutral position to become of positive or negative delta, thereby exposing a Market Maker to directional risk. Gamma risk can be overcome by taking Gamma Neutral Positions.
3. Volatility Risk
An increase in implied volatility in the market increases the extrinsic value of stock options while a decrease in implied volatility decreases the extrinsic value of stock options due. This is known as the Vega risk. Market Makers who hold an inventory of stock options could sustain a loss if implied volatility decreases.
4. Time Decay Risk
Time Decay or Theta risk is when stock option premium reduces as expiration date draws nearer even if the underlying stock does not move. A Market Maker with an inventory of long stock options can sustain a loss over time even if the underlying stock does not move.
5. Interest Rate Risk
Stock options, especially long term ones, are affected slightly by changes in interest rates. This change, although insignificant to most option traders, is significant to Market Makers who hold very large inventory of stock options. This risk is represented by the Options Rho.
6. Dividend Risk
Dividends declared reduces call option value as holder of the call option do not recieve the dividends. Such risks are usually hedged by Market Makers by buying the underlying stock ahead of it's dividend declaration. The dividends recieved then hedge against the decline in call option value.
Unlike independant option traders, Market Makers cannot sell off their inventory of stock options simply because they know these stock options are going to go down in value due to any of the above risks, that is why hedging is such an important skill to Market Makers.
How Does One Become A Market Maker?
One can only become a Market Maker by joining one of the Market Maker firms like Goldman Sachs or through a clearing agency or brokerage firm which is a member of NASDAQ. Most firms provide on the job training and requires applicants to have at least the following criteria :
1. A Bachelor's Degree
2. Excellent numeracy and analytical skills.
Most market maker firms also have entry examinations in order to ensure that applicants have the required numeracy and analytical skills. In fact, being a market maker requires a lot more than just being good with numbers as it also requires extraordinary mental strength to be a market maker.
Another way of becoming a Market Maker is by owning a trading pit in NASDAQ or LSE itself... something that is out of reach for most individuals.
Market Maker Questions
:: Who Is Bidding & Who Is Asking
:: Can I Sell Options For More Than What Market Makers Are Bidding?