Most market makers like to trade flat—that is, profit from the bid-ask spread and strive to lower exposure to direction, time, volatility, and interest as much as possible. But market makers are at the mercy of customer orders, or paper, as it’s known in the industry. If someone sells, say, the March 75 calls to a market maker at the bid, the best-case scenario is that moments later someone else buys the same number of the same calls—the March 75s, in this case—from that same market maker at the offer.
This is locking in a profit.Unfortunately, this scenario seldom plays out this way. In my seven years as a market maker, I can count on one hand the number of times the option gods smiled upon me in such a way as to allow me to immediately scalp an option. Sometimes, the same option will not trade again for a week or longer. Very low-volume options trade “by appointment only.” A market maker trading illiquid options may hold the position until it expires, having no chance to get out at a reasonable price, often taking a loss on the trade.
More typically, if a market maker buys an option, he must sell a different option to lessen the overall position risk. The skills these traders master are to lower bids and offers on options when they are long gamma and/or vega and to raise bids and offers on options when they are short gamma and/or vega.This raising and lowering of markets is done to manage risk.Effectively, this is your standard high school economics supply anddemand curves in living color.
When the market demands (buys) all the options that are supplied (offered) at a certain price, the price rises. When the market supplies (sells) all the options demanded (bid) at a price level, the price falls. The catalyst of supply and demand is the market maker and his risk tolerance. But instead of the supply and demand for individual options, it is supply and demand for gamma, theta, and vega. This is trading option greeks.
Delta is the easiest risk for floor traders to eliminate quickly. It becomes second nature for veteran floor traders to immediately hedge nearly every trade with the underlying. Remember, these liquidity providers are in the business of buying option bids and selling option offers, not speculating on direction.The next hurdle is to trade out of the option-centric risk. This means that if the market maker is long gamma, he needs to sell options; if he’s short gamma, he needs to buy some. Same with theta and vega.
Market makers move their bids and offers to avoid being saddled with too much gamma,theta, and vega risk. Experienced floor traders are good at managing option risk by not biting off more than they can chew. They strive to never buy or sell more options than they can spread off by selling or buying other options.This breed of trader specializes in trading the spread and managing risk, not in predicting the future.
They’re market makers, not market takers.There are some trading strategies for which market makers have a natural propensity that stems from their daily activity of maintaining their positions.While money managers who manage equity funds get to know the fundamentals of the stocks they trade very well, options market makers know the volatility of the option classes they trade.
When they adjust their markets in reacting to order flow, it’s, mechanically, implied volatility that they are raising or lowering to change theoretical values. They watch this figure very carefully and trade its subtle changes.A characteristic of options that many market makers and some other active professional traders observe and trade is the volatility skew.
Savvy traders watch the implied volatility of the strikes above the at-the-money (ATM)—referred to as calls, for simplicity—compared with the strikes below the ATM, referred to as puts. In most stocks, there typically exists a “normal” volatility skew inherent to options on that stock. When this skew gets out of line, there may be an opportunity.
Say for a particular option class, the call that is 10 percent OTMtypically trades about four volatility points lower than the put that is 10 percentOTM.For example, for a $50 stock, the 55 calls are trading at a 21 IV and the 45 puts are trading at a 25 volatility. If the 45 puts become bid higher, say, nine points above where the calls are offered—for instance, the puts are bid at 32 volatility bid while the calls are offered at 23 vol—a trader can speculate on the skew
reverting back to its normal relationship by selling the puts, buying the calls, and hedging the delta by selling the right amount of stock. This position—long a call, short a put with a different strike, and short stock on a delta-neutral ratio—is called a risk reversal. The motive for risk reversals is to capture vega as the skew realigns itself. But there are many risk factors that require careful attention.