In a couple of previous articles, I mentioned the role of Market Makers in the options market. These people make the market possible by standing ready to buy or sell options at any time. Of course, they’re not doing this as a public service. They make money at it (although not as much as they used to).
The option market makers’ profit comes primarily from the bid-ask spread on the options they deal in. They buy at the bid, sell at the ask, and make the difference. Many times, this means selling options that they don’t own – being short the options.
Looking at just Call options for the moment, we know that people who buy them have potentially unlimited profit. The higher the price of the underlying asset (“the stock”) goes, the more the call buyers can make, with no limit. Since every option contract is a zero-sum proposition, the sellers of calls have potentially unlimited losses.
Then aren’t market makers taking on a huge amount of risk, by being short a lot of options?
No, they’re not. They take on no risk at all related to movement of the stock price. They avoid that risk by using positions in the underlying stock itself as a hedge against their option positions. Here’s how it works: An option market maker sells 10 call contracts, representing 1000 shares of stock. As of that moment, every penny that the stock rises is going to take money out of his pocket and put it into that of the option buyer. To negate this, the market maker immediately buys stock himself. In that way, every penny that he loses on the option, will be made up for by a gain on the stock. Conversely, if the price of the stock goes down, the market maker makes money on the options, and now loses the same amount on the stock. The market maker is neutral as to the stock price – he doesn’t gain or lose if it goes up or down. His money is made on the option bid-ask spread.
Looking at our previous examples, can it be worthwhile for a market maker to buy stock worth $600, just to make a profit of… Continue Reading
