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When the Mystery Is Gone: Trade Like an Options Market Maker

October 13, 2013
When the Mystery Is Gone: Trade Like an Options Market Maker

Options market makers don’t hold the secret formula. They’re just doing their job.

In The Wizard of Oz, Dorothy and her friends go to see the all-powerful wizard believing that he can solve their problems. Instead, they discover that the man behind the curtain is simply an elderly illusionist.

If you’re an options trader, you can probably relate. Who’s the mysterious person behind the curtain who takes the other side of your trade? And why are they willing to do it? After all, if you’re placing a trade that you’re convinced will be a winner, why would someone else want to take the “losing” side?

For starters, options market makers are not all-powerful wizards. They are simply professional traders who are paid to take risk and provide market liquidity in order to make it easier for us little guys to enter and exit trades.

Same Motivation, Different MO

It’s important to realize that there are key differences between how retail traders—you, sitting at home in front of your computer or trading on your smartphone—and the market makers, the professionals, build and manage positions. Retail traders choose to enter any position they like, using any stock and any option strategy that they fancy. Market makers build their positions (also referred to as “inventory”) primarily by taking the other side of retail trades. For some, this begs the question: is option trading a zero-sum game? If a retail trader sells, say, a call option, and a market maker buys that call option, can there be only one winner and one loser, or can both sides potentially profit? Let’s find out in the following example.

Suppose a retail trader who owns 100 shares of a stock decides to sell a covered call, which is a common strategy. With the stock trading at $75.21, she decides to sell the September $77.50 call for a premium of $1.13 (figure 1). She’s then obligated to sell her stock at $77.50. In return, she collects a $113 premium (less commissions and fees). That premium is hers to keep regardless of the trade’s outcome.

Sample weekly option chain

FIGURE 1: Sample weekly option chain on the thinkorswim® paperMoney® platform. For illustrative purposes only. Past performance does not guarantee future results.

Now, assume that a market maker takes the other side of this trade and buys the call option. Why would he buy an option that is out of the money (OTM)? An OTM call option has a strike price that is higher than the market price of the underlying asset (a put option has a strike price lower than the market price). OTM options have a higher likelihood of expiring worthless. Does he know something that the retail trader does not?

Not likely. The answer lies in the fact that an option is a derivative—its price is derived from the underlying stock, and that stock can be used to hedge the position. Market makers hedge the risk of option trades by simultaneously buying or selling stock. In this example, the market maker could sell shares of stock short to possibly help offset the risk of buying the call option. If the price of the stock declines, the loss on the call option might be offset by the gain in the short stock position used as a hedge. In theory, both sides can potentially profit from being on opposite sides of the same trade depending on the steps they take to hedge their respective positions.

Inventory Control

When market makers manage positions, it’s not all that different from any business owner storing stockpiles of a product. Think of a farmer who has a lot of corn to sell. He doesn’t know exactly where the price will be when it’s time to sell, so he can hedge that price risk using another type of derivative—futures contracts that lock in a sales price. Market makers don’t know exactly where the price of the underlying stock will be at expiration, so they often use stock, options, futures contracts, or other derivatives to help them manage risk.

That’s right. The person on the other side of the curtain does not have all the answers. Market makers are simply professional traders who think about their positions a little differently than you do. It’s that different way of thinking that deepens markets for all who use them.

Start Experimenting with paperMoney®

Trading and risk. They’re like peanut butter and jelly. But paperMoney lets you test-drive strategies and get comfortable with thinkorswim using virtual accounts, so you don’t have to risk a dime.

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