Pulling Back the Curtain: The Role of an Options Market Maker

Pulling Back the Curtain: The Role of an Options Market Maker

Key Takeaways

    Options market makers are professional traders, paid to provide liquidity to the market

    The competing objectives of different market players, such as market makers versus retail traders, can make for a vibrant, liquid marketplace

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’re simply professional traders who are paid to take risk and provide market liquidity in order to make it easier for retail traders 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. Options market-making strategies involve building positions (also referred to as “inventory”) primarily by taking the other side of retail trades. For some, this begs the question: is options 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 with an 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 $191.88, she decides to sell the September 205-strike call for a premium of $1.99 (figure 1). If the stock trades above $205 at or before expiration, she may be obligated to sell her stock at $205. In return, she collects a premium of $1.99 x 100 (the multiplier for standard U.S. equities), or $199, less commissions and fees. That premium is hers to keep regardless of the trade’s outcome.

Pulling Back the Curtain: The Role of an Options Market Maker

FIGURE 1: OPTION BID/ASK, THEORETICAL VALUE, AND PROBABILITY OTM. According to the Prob OTM function, the 205 calls have about an 80% chance of finishing out-of-the-money. Why might a market maker be a buyer at $1.99? For illustrative purposes only. Past performance does not guarantee future results.

Note the left-hand column of figure 1, Prob OTM, which is, you guessed it, an estimate of the probability an option will be out-of-the-money (OTM) at expiration. It’s one of many tools in the thinkorswim® platform to help options traders gauge theoreticals and risks (aka “greeks”).  

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 has a nearly 80% chance 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.

Market Makers: They’re All About the Math

And there’s more. It all comes down to market maker tactics and market making strategies, and how they may differ from those of retail traders. At the base level, both have the same objectives: maximizing returns and managing risks. How they go about it can differ. Refer back to figure 1. Note the second column, Theo Price, which for the 205-strike calls is $2.02. Market makers use theoretical pricing models to determine probabilities given certain inputs such as days to expiration, price of the underlying, interest rates, and the amount of variability in the underlying (“volatility”) to determine a theoretical value of an option. 

A market maker who can buy below and sell above theoretical value can, over time, come out ahead. Sure, each instance may have a low probability of a positive outcome (like our example, buying a call with an 80% chance of finishing OTM). But that also means a 20% chance of being in-the-money, perhaps by a lot. The point is, an options market maker who may be trading, at any given point in time, hundreds or even thousands of different strikes in a number of stocks is not focused on the individual trade, but rather the mathematical advantage that market makers call “edge.” If he or she can consistently collect edge from individual trades, he or she can, over time, and with prudent risk management, “actualize the theoretical.”

Though we typically avoid gambling analogies—after all, prudent investing is not to be equated with gambling—sometimes it helps to conceptualize. Consider a roulette wheel. It has 38 spaces, and the house typically pays out 35-to-1. Sometimes the house makes a big payout, sometimes a small one, and sometimes the house collects. But each time, the house has a slight mathematical advantage. So, over time, the house makes money, even though some individual players might do well.     

Another Market Maker Technique: Inventory Risk Management

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. Options market makers are simply professional traders who might 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.

Are options the right choice for you?

While options are definitely not for everyone, if you believe options trading fits with your overall investing strategy, TD Ameritrade can help you pursue your options trading strategies with powerful trading platforms, idea generation resources, and the support you need.

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