The Market Makers’ Edge in Option Trading

Basic Terminology

Let us first get some basic terminology out of the way so that we can make sure we are all on the same page.

  • Market Maker – A market maker is any firm that is ready to buy and sell a particular stock or commodity on a regular and continuous basis, as a publicly quoted price.

 

  • Option Trading – An option trading contract is one that awards the buyer with the right (but without any obligation) to buy or sell an underlying asset at a specified price on or before a given date. As such, the buyer has some freedom of choice as to when to buy or sell.

What Exactly is Option Trading?

As we have already mentioned, option trading is a type of stock or commodity trading which functions much like a security. Let us give you an easy example. Suppose you want to purchase a house but you will not have enough money for about another three months. So you negotiate with the owner and settle on an option where you will buy the house in three months for a price of $200,000, but you have to pay $3,000 for the option.

Two things may follow after this. Firstly, it may be discovered that the house was the birthplace of a famous public figure. This would skyrocket the value of the house to $1 million. Hence, you stand to make a profit of $797,000. However, it is also possible that you discover that the house is infested by rats, hence making its value to you fall to $0. Since you bought the option, you are under no obligation to go through with the sale. Therefore, you only lose $3,000 (since you bought the option for $3,000).

So as you can see, the option trade protected you; you don’t have to lose the $200,000 for the house after realizing that it is, in fact, worthless to you. You only incur a much smaller loss of $3,000, which is definitely a good bargain compared to what you could have lost.

The Market Makers’ Edge

So now that we fully understand all the terminology, it is time for us to get to the point. Why does the market maker have an advantage in option trading?

Relative Pricing

Market makers usually spread their options against other options, or the underlying stock or index futures. In essence, all market makers look for a synthetic arbitrage trade, where a trade can be combined with other trades in order to produce a profit, but at a very low risk level.

However, in order to do that, one must know what is mispriced, in order to gain (recall: if you originally knew that the house was the birthplace of a famous person but was mispriced at $200,000, then you stand to gain by purchasing that option).

Arbitrage Spreads

One other advantage that market makers have is that they usually do not need to worry about whether an option they are purchasing is over-priced or under-priced. What matters to them is whether the option is mispriced relative to other options at any given point in time, because this will allow them to create a spread to reduce the risk of buying or selling the said option.

Still don’t get it? Look at it this way. Market makers can take advantage of any mispricing and cancel out risks by buying relatively under-priced stocks, and at the same time selling relatively over-priced stocks. The margin will then balance out to a profit. This is, in fact, a basic pricing technique which is fundamental to how a market maker operates.

Little Trading Or Brokerage Fees

Another minor advantage that the market maker has in option trading is that they pay little or no trading or brokerage fees since they are exchange members or over-the-counter dealers. This stands to increase their gross profits by a certain degree.

Making Informed Choices

Market makers are able to calculate their cost of participating in option trading by using interest rate plays. In other words, using his own appropriate interest rate, the market maker will calculate his cost to derive the size of the debit or credit that would make a commodity or stock trade profitable. With that, the market maker can examine current option prices and determine if they should be purchased or sold, or otherwise.

Particularly, market makers have the needed information and expertise to make a more informed choice of whether to purchase or sell an option. This is essentially the factor that gives them an edge in option trading.

An Example of the Market Maker’s Edge

In case you are still a bit confused, here’s a concrete example to make things a little clearer. Suppose XYZ Company’s shares are trading at $10. This means that if you own the stock, you gain and lose a dollar for every dollar that the stock rises or falls above or below $10, respectively. If you own a $10 call, at expiry, the call will be worth a dollar for every dollar above $10. But if you own a $10 put, you lose a dollar for every dollar below $10.

For instance, if you had a long call and a short put, they would be synthetically equivalent to owning stock. At expiry, if you have a long call and a short put, you will have a net gain or loss that is equivalent to any changes in the stock price itself. Hence, it can be said that you have eliminated the exposure to the direction of price movement (i.e. you have eliminated your position risk).

Now, suppose a market maker has 10 calls, trading at 45c, and the puts are trading at 35c, when the underlying trade is at $10. All he has to do is to sell the calls, and buy the puts and stock. This will result in him earning 10c, and at the same time, the method will hedge away any exposure to changes in price of the stock. Ultimately, this means that he earns $6 from this option (since options typically cover 100 shares).


 

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GBPUSD 1.32030 1.32060 3
USDCAD 1.27820 1.27850 3
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AUDUSD 0.75560 0.75590 3
NZDUSD 0.68060 0.68110 5
EURGBP 0.89270 0.89300 3
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EURJPY 132.150 132.180 3
AUDJPY 84.700 84.750 5
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