How the Market Makers Lose

The Smart Profits Report: Issue #252
Thursday, October 20, 2005

How the Market Makers Lose: Uneven Trades and Open Positions
By Lee Lowell
Advisory Panelist, Mt. Vernon Research

You might think that market makers are out to get you, but after spending seven years in a NYMEX options pit, I can safely say they have much bigger problems to deal with., such as how these market makers lose money.

Continuing my Market Maker series, I’d like to share some of the hardships these traders face in their day-to-day operations. And I hope it will make you feel better about them.

Today, we’ll look at two issues that can wreak havoc on the option market maker: “one-way” positions and “pin risk.” During my time in the options pit, these two issues were some of my biggest stresses.

Here’s why…

Three No-Win Choices… At the Broker’s Mercy

When an options market maker makes a trade, he usually does the transaction with a pit broker, and sometimes with other market makers. That initial position will give them a long or short directional bias, which they offset with a futures transaction to keep the risk neutral. Besides keeping the directional (delta) risk neutral, option traders also need to balance out their gamma, vega and theta risk. I won’t go into detail on these, but suffice it to say, these are just as important measures of risk as delta.

Many times, multiple brokers in the pit will get very similar orders to take positions in the same options. It is the market makers’ job to take the other side of those trades. When many of the brokers are doing the same trades for their customers, the market makers can end up with lopsided positions, heavily weighted in one direction with respect to delta, gamma, vega and theta. They’re stuck on a “one-way” street.

The Market Makers Position: Long or Short?

This means that a market maker’s position can be extremely short or long options, and that can be very damaging to his profit/loss scenario. But they have no choice. They have to make the markets and trade with the brokers. If the markets end up doing what the broker’s customers thought it would, the market makers are on the other side of those trades… and the losses can add up very quickly.

So, what’s the market maker to do in this case? Often, they have no choice but to ride out the storm and see if the market helps or hurts them. They can also wait to see if the brokers decide to turn tail and unwind all the positions they just initiated. Other times, the market makers are forced to make trades that will balance out their lopsided positions, but at unattractive prices.

Now, let’s look at the second way a market maker can end up too heavy…

Overly Exposed With 100 Open Contracts

“Pin risk” occurs when the market maker has a sizable stake in a conversion or reversal position. These are three-sided trades that include a long and short option position of the same strike price, offset by a corresponding futures trade. The trader is either long a call and short a put with a short futures trade, or short a call and long a put with a long futures position. These are riskless trades that the market makers place for fractions of points, and they only cause trouble when the futures contract settles exactly at the strike price on expiration day.

Let me give you an example…

Let’s say the current price of a November crude oil futures contract is $63.77. Our market maker is long 100 crude oil $64 calls, short 100 crude oil $64 puts, and short 100 futures contracts. On expiration day, if the futures price is above $64, he will exercise his long calls, which will be offset by his short futures contracts, leaving him with a zero position. If the futures price is below $64 on expiration day, he will be assigned on his short puts, which requires the market maker to become long on the futures contracts. Again, this will be offset by his short futures contracts already in the account, thus leaving him with a zero position.

Market Maker’s Choices: To Lose Or Not To Lose

But, what happens when the futures price settles exactly at $64 on option expiration day? Does the market maker exercise his long calls, or does he think that he will get assigned on his short puts? Nobody knows. And the problem is that this must be done by a cutoff time, and there is no way of knowing beforehand what the other side is going to do.

If the market maker decides to exercise his long calls, but also gets assigned on his short puts, he will be long 200 futures contracts that will only be offset by his original short 100 futures position, thus leaving him with an open position of long 100 futures contracts. This is a very dangerous situation. Nobody wants to be left with a large open position like that over the weekend.

If this happens, he’s forced to make a judgment call on how many contracts he thinks will be assigned, versus how many of his long calls he should exercise. He only has 100 futures contracts in this case, so he needs to balance out the amount he thinks he should exercise against what he thinks he will be assigned. Sometimes this is done on a Friday expiration day, and he won’t find out until Monday morning what position he’s left with. It can be very hairy at times.

These are two of the most stressful position-management situations that I had to contend with during my days as an options market maker, and they still trouble many of the traders working on the exchanges today. You might think the market makers are always out to get you, but sometimes they have bigger problems to deal with.

Good trading,

Lee

Today’s Smart Profits Cribsheet

Check out the Smart Profits Glossary for definitions on terms such as “market maker” or “option contract.”

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Smart Profits Report Archive

=”normal”>The Smart Profits Report: Issue # 254
Thursday, October 27, 2005

Derivatives Markets: “Textbook” Trades Don’t Always Win
By Karim Rahemtulla
Chairman, Mt. Vernon Research

Last week, I spoke to economics students at Rollins College, in Winter Park, Florida, my alma mater. The topic was the derivatives markets - those that deal with futures and options. The professor who invited me was Dr. Harry Kypraios - the same teacher who taught me some 23 years ago.

I tried to think back to my first exposure to derivatives, and how much I hated the topic. I’m sure many of you have kids or grandkids who are in college right now, wishing they could just make it through courses in derivatives, calculus, statistics, etc. These are not high on the favorites list for many of us. I tried to be humorous in my talk, exposing the group to the “real-life” experiences of trading derivatives, versus learning about them.

In the real world, I lectured, derivatives trading is much more complex than theory. There are a host of factors that the textbooks just don’t cover. For example, they don’t mention market makers, news events, market manipulation, uneven bid/ask spreads, bad brokers, bad traders, and contra-accounts that have been the downfall of many trading houses like Barings. Textbooks don’t mention that the derivatives markets are run by a sort of “brotherhood” of traders and exchanges whose motivation is profits… and not advancing education.

Then I explained the importance of cynicism… I admit, it may have been callus of me to reveal some truths about investing at such an early and tender age.

Getting Sacked By An “Enron,” Then Back for More?

Since I received my graduate and postgraduate degrees, I have become much more cynical, too cynical, as my significant other constantly reminds me. I remind her that my cynicism is borne of experience, not from reading too much.

Cynicism is, in my opinion, one of the strongest tools an investor should possess. The market is not made up of cute and cuddly textbook writers who were comfy in their professorial responsibilities before deciding to cave into the pressures of their department chairs and write college textbooks. Rather, it is made up of profit-hungry specialists whose aim is to part you from your money.

Derivatives Markets: Bastions of Wealth

The derivatives markets as well as the other markets are the foremost bastions of the greatest legal transfer of wealth in the world today. Each day you make bets on what you think are wholesome and legitimate enterprises. Then comes the reality - Refco, Worldcom, Enron, Hedge Funds, Mutual Fund kickbacks, non-existent corporate governance. We shake our collective heads, and the next day we start again, blindly pledging our trust to a system that we know is stacked against us.

Cynical? You bet I am. Contrarian? Yes sir, that’s me. It has served me and my readers well to not believe everything we read or hear. I don’t regret a moment of my education, from boarding school in England, to university in the States. What I do regret is the lack of textbook writers who write from experience, with candor and fortitude, and tell it like is… and not like it should be.

Good Trading,

Karim

Today’s Smart Profits Cribsheet

While textbooks don’t beat experience, there is an options book I highly recommend. And you can get it for free… Characteristics and Risks of Standard Options is a valuable title - and you can’t beat the price. To get your copy, just call 888.OPTIONS, or write to the Options Clearing Corporation, One North Wacker Dr., Suite 500, Chicago, IL 60606.
Check out the Smart Profits Glossary for definitions of words like “derivatives” or “market maker” found in today’s article.

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