The binary option trading is not an automatic match between buyers and sellers. There is another component to the process: the market maker.A market maker provides the liquidity. The essential role of the market maker is in fact to make the market. As familiarity with the binary option product increases, more market makers will be attracted to the opportunity.But, let’s get a deeper look at how the market maker fulfi lls his duty.
Nadex has an agreement with Market Risk Management (MRM), which is an entity of IG Group, to price all markets on the Nadex exchange.To understand market making with the binary options, I asked John Austin, a former market maker and one of the originators of the binary option product, to describe market-making from his vantage point. He provided the following point of view: We need to begin with the traders.
One trader looks at a price and wants to buy, while another trader looks at the same contract and wants to sell.For example, the market maker makes a price at 48–51.In a perfect world, two individual traders see the price and trade at the same time. One thinks the price is too high and goes short in 1 lot at a price of 48. The other thinks the price is too low and goes long in 1 lot at a price of 51.
Both traders wait until expiration, and do not trade again, and neither does anyone else.In this perfect world the market maker has fulfi lled his duty (i.e., he has put liquidity onto the exchange and provided a tradable price for traders who don’t want to work an order but would rather trade right away), but has left himself with absolutely no exposure to the fi nal expiration level.
He has bought 1 lot from the selling trader at 48 and sold 1 lot to the buying trader at 51, making a 3 point profi t for himself, regardless of where the market settles. This 3 point profi t is his reward for posting prices and taking risk.In the real world, individual traders rarely choose to trade in opposite directions in identical sizes at the same time (if they did, there would be no need for market makers).
In the real world, the market maker posts a price that may start at 48–51 before moving smoothly to, say, 78–81 and then dropping suddenly to, say, 19–22 and so on. Buyers and sellers come along more or less at random, buying or selling on the market-maker’s price in different sizes at different times. When the market maker sees a whole bunch of people buying a certain price he may tweak his price upwards by a point or two, to encourage some sellers to enter the market and balance his risk.
Alternatively, a whole bunch of people selling a certain price may cause the market maker to tweak his price downwards by a point or two, to encourage some balancing buyers.In practice, market makers are rarely able to balance their book perfectly,and end up wearing a position until expiration. So on any one expiration, on any one contract, the market maker may make a large loss or a large profi t.
But, averaged over many contracts, over the course of a year, the effect of the market maker’s spread should be to make the average price at which he buys from traders slightly lower than the average price at which he sells to traders. That is his reward for providing liquidity, and it is paid for by the fact that losing traders lose, over the course of a year, slightly more than winning traders win (because binary trading, like spot FX and all other derivatives trading, is a zero-sum game).
Understanding the role of market makers provides a better understanding of the real dynamics of binary option trading and why it is possible with honed trading skills to gain an edge in binary option trading and have winning bets.The actual bid and ask prices are not just the expected probabilities of bearish and bullish traders. It would be wrong and naïve to interpret the bid and ask prices as a simple refl ection of expected probabilities. The fact is that they also refl ect adjustments the market makers make to encourage participation. The market maker wants more volume because over time, he will gain a fraction of the spread.