Market Maker Insight

The Smart Profits Report: Issue #304
Saturday, April 29, 2006

Market Maker Insight: Three Reasons They’re Not Enemies
By Lee Lowell
Advisory Panelist, Mt. Vernon Research

As I was speaking at an options seminar in Puerto Vallarta a few weeks ago, I had a chance to meet a lot of the attendees face-to- face after the first day of presentations.

Many of them were intrigued by what life was like working as an actual market maker and wanted some market maker insight. Lots of attendees were surprised when I told them that the job wasn’t that easy.

Contrary to what many off-floor traders think, the market maker isn’t really the enemy. In fact, they are to thank for making options trading possible for investors like us. Here’s how they do it…

Market Makers: They Are Not Out To Get You

First of all, it’s not a glamorous life. I saw my fair share of floor traders come and go while trading in the Crude Oil options pits on the New York Mercantile Exchange (NYMEX). Being a market maker is a learned skill, just like any other job. If you can’t figure out how to do it, your life expectancy on the floor is going to be very short. Not every trader that walks into the pit is going to be successful.

The way the market maker truly makes money is by having a balanced portfolio of buys and sells, all with an “edge” locked in. The edge is the difference between what an option trader’s “theoretical trading sheets” are telling him to buy or sell an option at, and what price he actually ends up buying or selling it for in the marketplace. The wider the difference between “sheets” and actual prices, the bigger the profit will be.

These trading sheets are the lifeblood of the trader. They are run off of sophisticated option-pricing models that tell the trader what each option strike is worth at any moment in time. Their job is to buy the option under “theoretical price” and sell it for more.

A lopsided position will occur when all the brokers want to buy or sell the same position, leaving the market maker with too many buys or too many sells in their portfolio. If the market moves in the direction that all the brokers want, the market maker will be the one taking the losses. You just can’t avoid that situation if you’re a market maker. It just happens.

At that point, you will see market makers doing all they can just to even out their portfolio. Many times, this can entail either selling or buying below fair value just to balance out the risk. I’ve done it, and I saw many of my fellow market makers do it, too.

Three Challenges The Market Maker Faces

Getting Speedy, Spot-On Quotes

Most off-floor participants think the market maker is always responsible for their bad fill prices. Believe me, you as an individual trader are the farthest thing on the mind of any option’s market maker. They are more worried about how fast they can supply the brokers with accurate quotes, how many contracts they can get from those brokers, and how fast they can lay off the delta hedge with their point man (the guy that helps the option traders get their futures trades done).

Managing Directional Risk

Market makers aren’t on the floor to pick a direction on a stock or commodity and then hope it moves in that direction. They are not in direct competition with you on that level. The market makers are there to supply the brokers with bid and ask quotes all day long, hoping to buy on their bid price and/or sell it back on their ask price.

If they can’t immediately sell something that they just bought, or buy something back that they sold previously, the option market makers must lay off their directional risk of that trade with an opposing trade in the futures market. At that point, the option trader is at the mercy of the futures market being at the same level as when they initiated the option trade. Any movement in the wrong direction of the futures market, and the option trader starts losing the “edge” on that trade.

And the “edge,” like these other obstacles, is what makes the life - and profitability - of a market maker very difficult…

They have no idea that you, Joe Smith Trader, are on the other side of a trade. All they know is that your broker is executing lots of contracts for either a large customer or for many traders who want to get in on the same trade. The only way the option trader will take the other side of that trade is if he knows he can lay off his risk with an opposing trade in the futures market.

The point man is responsible for accurately quoting - with hand signals - where the futures market is at all times. The risk comes at this point of whether the option trader can execute the hedge trade at the same level he was quoted by his point man. All it takes is a few seconds to execute the option trade and send the order to the point man, but those few seconds are sometimes long enough for the futures market to move adversely and leave the option trader with an unprofitable trade.

Always At the Mercy Of The Market

One of the other obstacles standing in the way of the market maker being profitable is the fact that he must always be there ready to make a market and trade under any condition.

The problem in this scenario is that many of the broker’s customers will initiate the same trade at the same time, sometimes all day long. The market maker is obligated to keep selling or buying those options from the brokers, leaving the market makers with a very one-sided position consisting of all long positions or all short positions in the same strike price. That is a potentially life-threatening situation - financially - for a trader.

Insight Into The Market Maker’s Minds

Believe me, market makers are not concerned with whether you think orange juice is going up or whether coffee is coming down in price. They just want to make sure they can give accurate quotes to the broker, get involved with as many trades as they can, and be able to effectively get their futures trade executed at the desired level.

That’s how it’s done, and if the market maker sways from that plan, he will not be around that long. Instead of thinking of them as the enemy, think of them as the ones who make it possible for you to trade any option at any time.

Good Trading,

Lee Lowell

Today’s Smart Profits Cribsheet

Lee’s put together a series about his days on the floor of the New York Mercantile Exchange. What goes on in the “pits” during market hours? How “big” is the money that crosses the floor? Do seconds really matter? Find out by taking a look at his Smart Profits Report #241, Market Makers: Hand Signals, Stress and Million-Dollar Trades in the NYMEX Options Pit.

As always, check out the Smart Profits Glossary for definitions of words like “market maker” or “bid & ask” found in today’s article.

If you’ve been paying attention to gold prices lately, you’re no doubt intrigued by $630 an ounce. Just last week, expert trader D.R. Barton, the Chairman of Trader’s U, put together a detailed action plan if you’re holding gold now or thinking about adding it to your portfolio. I urge you to take a look - Today’s Gold Prices: Is There Still Time To Jump In and Invest? (Don’t Get Burned by the New Gold Rush).

Related Articles: