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Spread Trades & The Market Maker
The Smart Profits Report: Issue #216
Monday, June 13, 2005
Spread Trades & The Market Maker - Two Valuable Options Lessons From Boston
By Karim Rahemtulla
Chairman, Mt. Vernon Research
When was the last time a market maker from the NYMEX shared his secrets with you? Or an oil trader from the pits in New York explained how he covers $17,500 a month just for the privilege of trading on the floor?
These were just a couple of the insights at the recent Options and Traders Conference in Boston, where the line-up of speakers and information was excellent. But they weren’t the only profitable secrets investors heard about.
Today, I’m going to share with you two of my favorite secrets that the audience found profitable.
- One of them is among my favorite ways to play options. It allows you to limit risk without capping your profit potential too tightly. This is the “spread” trade. Less than 1% of traders out there are using it, but today I’ll give you the inside scoop on how it’s done, so you can start making gains right away.
- The other secret has to do with market makers. In fact, it answers that long-held enigma: What do market makers really do? Once you know the answer, you might not want to blame the market maker the next time you don’t get filled.
Let’s dig right in, starting with spreads…
Anatomy of the Perfect Spread Trade
In a spread trade, you try to limit your downside risk in exchange for some limitations on the upside… How? You buy and sell options in such as way that you buy at one price and sell at another price.
There are several types of spread trades. Some are based on time; some on price; some on other factors…
I like to use spreads AFTER I am already profitable in a trade. This way, I can pull most of my money off the table and maintain a very healthy profit target.
An example of this trade was when we shorted crude using the XLE LEAPS (long-term options). We bought the XLE puts for $2.45, and when oil fell, we were able to sell another put with a lower strike price (a bear put spread) and recoup ALL of our investment that we made in the initial trade.
This way we have $0 at risk to make $2 per contract if we hold until expiration and the trade moves in our favor. At worst, at expiration we will lose $0 on a 10-contract trade, and at best, we will make $2,000 on the same trade. Who says there is no free lunch?
Another time that I like to use spreads is when an option is very expensive. In order to reduce my cost and exposure, I will engage in a spread. This way I will still make a profit if the trade goes well, but I can cut my risk by 50% or more in case it goes sour.
I was happy to see that many of the top professionals in the industry not only embraced spreads as a sound strategy, but also were using it on a daily basis to rein in risk.
Dispelling Market-Maker Myths
The second secret that came out of Boston answered the age-old question of what market makers actually do…
This revelation came from one of my favorite options experts, Lee Lowell.
Some questions the audience asked were: Are market makers manipulative? Do they “suck” ordinary traders out of their positions? No, says Lee, because it’s really not in their best interest.
Lee was a market maker on the NYMEX for seven years. He knows his stuff. As he put it: “It’s not always the market makers who are playing the games. I should know: I was one of them.”
So what does a market maker actually do?
“In the simplest terms,” says Lee, “a market maker helps facilitate the execution of a trade by providing a continuous bid-and-ask market for a futures or options contract to any interested party.”
He also says market makers aren’t out to get the average trader: “When you ask your broker for a quote from the floor (which you should always do before placing ANY futures option trade), the market makers don’t know whether you want to buy or sell, so they aren’t out to get you.”
As Lee points out, a seat lease on the NYMEX costs about $17,000 a month, and a seat to buy cost $1.8 million! If you’re a market maker who leases a seat, you’re already in the hole $17,500 come the first of the month.
So in order to survive, you simply MUST provide a continuous flow of good, fair and quality quotes.
Next time your order doesn’t get filled, you might not want to automatically blame the market maker… You might want to have a little talk with your broker, instead.
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Today’s Smart Profits Cribsheet
- Check out the Smart Profits Glossary, chock full of over 150 option terms like “spread trade” & “market maker” found in the article above.
- Lee Lowell talks more about the market makers in Smart Profits #241, Market Makers - Hand Signals, Stress and Million-Dollar Trades.
- Looking for another article on spread trades? Swing on over to Smart Profits #280, Spread Trades: Bull vs. Bear.
Good trading,
Karim
Related Articles:
- What Market Makers Really Do
- Understanding Bull Spreads - Make 1,000% or More by “Spreading” the Wealth
- Liquidity & Limit Orders - An Options Balancing Act
