Options Market Makers

The Smart Profits Report: Issue #119
Thursday, June 17, 2004

Options Market Makers: Two Rules for Beating the Market Makers
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

The options market makers are at the top of the food chain - and they aren’t shy about exercising their Darwinian advantage. Like their brothers at the stock exchanges, they create and control a market for buyers and sellers.

In stocks, we typically call that “an orderly market.” With options, it’s more freewheeling: the stronger against the weaker, the more knowledgeable against the naive.

Until recently, options market makers operated in relative obscurity, doing most of their business with large institutional clients who use the options markets for investing and hedging.

The Coming of the Speculators

But now that the general public has realized the power of trading options, the market makers have found fresh prey.

Most of these new investors aren’t calmly hedging their portfolios against losses, like fund managers and big companies have done for years. The new players are there to speculate, and they’re in a hurry. You may be there to speculate as well… It is, after all, a profitable pastime.

But you need some “institutional” calm if you want to win. To beat the options market makers at their own game, you need to slow down and understand who they are, how options are supposed to work, and what actually happens in real life.

Kevin Rubash of Bradley University looked into the work of options market makers in his “Study of Options Pricing Models.” Although options pricing is mathematically complex, he found:

“Financial analysts have reached the point where they are able to calculate, with alarming accuracy, the value of a stock option. Most of the models and techniques employed by today’s analysts are rooted in a model developed by Fischer Black and Myron Scholes in 1973.“

We will be discussing the fine points of the Black-Scholes model later, so that you can decode it (which turns out to be fairly simple) and use it to your profit. For now, what you need to know is that the Black-Scholes model is the basis for options valuations both in the markets and at individual corporations that issue employee stock options. I will refer to it as the BS (no pun intended) model.

The word I want you to pay attention to is “value,” which I highlighted in Rubash’s quote.

Position Yourself for Trading-Floor Reality

While the BS model is an accurate predictor of value, it doesn’t reflect the truth of the options market at the level of day-to-day practice. And once you learn where the aberrations are, you can use them to profit, just like the pros do.

The truth is that the options market bases the initial value of an option using the BS model. After that, anything goes. The market makers step in and mess with the prices.

For you, the game is to find and exploit the inefficiencies and oddities. And to beat the market makers.

The options market makers are masters at pricing stock options. This is how they make money. They follow the news, they gauge sentiment, they have groupies who feed them information. With that information, they can guess where demand is going to pop up, and then move the prices on offer to their advantage. These factors are not in the BS model. These are the profit-margin factors.

Option Market Makers Are Watching: How CNBC Can Cost You Profits

For example, if a talking head on CNBC recommends a stock that happens to have an option attached to it, the market makers automatically inflate their offer price by a dime or 15 cents. You pay a little extra; they make a little more profit

But here’s the big crunch. The bid does not change. And the spread between the bid and offer grows wider. So not only do you pay more to get in (the offer or ask price), you’ll get less when you sell at the bid price.

The market makers understand that a good number of investors who sit glued to CNBC for tips are pure speculators - and typically not sophisticated enough to know they are signaling their intent by staying with the crowd. Easy pickings.

Media hype and the artificial demand it creates is not only short-term in nature… it is not accounted for in the BS options pricing model. The price of an option, say a call, “shouldn’t” go up unless the underlying stock does, according to BS. Only one component of the BS model, the “current stock price,” is affected by the pile-on of CNBC-driven buyers. But in real life, demand does give the options market maker room to play.

The effect snowballs and continues to hurt the unwary even after the pulse of sudden demand is over for the option. Eventually, with all the media-driven interest, investors may buy enough of the stock to move the price up. But does the option become more valuable? Often not. It was overpriced earlier and it stays right there even though the stock rises.

Don’t Travel In the Middle of the Crowd

If you get caught in this movement, it will go against you. Sometimes, you will see the offer price of your option go back down even if the stock doesn’t change… And sometimes it will go back down even if the stock moves up a little bit. Worse, the real value of the option to you now - the bid price - has not budged. You are effectively losing money right away.

There’s always a spread between the bid and ask (what the option is worth in your hands and what you have to pay for it). But after an event like this, that spread becomes wider than usual. It will take a strong movement in the stock to overcome that hurdle.

Here’s an example…

Let’s say you buy 10 contracts of an option right after a CNBC report or other such news. You might find the bid at $1.70 and the offer (or ask) at $2. So you’ll pay $200 per contract, or $2,000 total. If you had to liquidate, you would sell at the bid.

Ouch! That is only $1.70, or $170 per contract and $1,700 back in your pocket if you get out of the whole position. You just lost $300 right away - without any movement in the underlying share price. You’re already 15% down.

But if you’d gotten there before the CNBC crowd, you’d have done better. You might have found the option was trading at $1.70 by $1.80, only a 5.5% spread to overcome. Even waiting a day or two after the big rush may bring the spread back in your favor.

The extra 20 cents on the offer price after the CNBC tout was pure manipulation by the market maker. Knowing demand was coming, he moved the offer from $1.80 to $2, just like that.

Two Rules to Turn the Tables - And Make an Options Killing

So how do you beat the market maker?

Use your limit orders. You’ll either get in at a better price, or you won’t get a fill, which is fine because you don’t want to pay too much anyway.
If there’s unusual volume, wait a bit until the flurry dies down. Most of the time, you’ll find better prices the next day. Of course, you may miss getting in. But again, if you pay too much and accept too wide a spread, chances are you would have lost money anyway.

Professional options traders don’t trade on emotion. A good trait to emulate.

Good Trading,

Karim Rahemtulla