Some Thoughts On Option Market Maker

Nope! Don’t enter your orders into your broker’s software the night before. You do not want them to execute at the market open.

The ups and downs of the markets are hard to predict. Let’s say that you put in an order to buy 10 at the money (ATM) calls on XYZ the night before. That means that your online broker will purchase your calls at the market price at the open of the market.

In the event of a direct market access broker, the price of the CFD will be similar to that of the underlying market instrument. The DMA broker makes his money by charging a commission.

Continuing On…

If something has happened the night before, such as rioting in Egypt, the market will likely correct downwardly in the United States. This happened January 28, 2011. President Hosni Mubarak sent troops and armored vehicles into Egyptian cities on Friday in an effort to quell street fighting and mass protests demanding an end to his 30-year rule.

Your broker would have bought your calls for you as your ordered. However, you would have made a substantial loss on your options.

Your broker has in his queue, many orders to purchase calls on XYZ, in our example. Consequently, with all those buy orders being submitted, the price of your calls will rocket up, only to come down after the flurry of buying has passed-usually at about 10:30 AM or 11:00 AM. You were immediately hurt even though the market continued up late in the day. If the market goes down instead of going up, you’re hurt even worse. I would suggest that you wait until the gush or orders has been filled before you consider purchasing options.

Market makers have the task of making a market for options on XYZ. Making a market means that if his asking price is high at the open, your order will be filled, irrespective of his asking price.

Let’s say that XYZ’s call option normally sells for $3.00. In fact, let us say that the most recent trade the night before, on this option was $3.00. When the market maker sees that he has 1, 000 at the market orders for calls on XYZ, he’ll raise his price for those calls. Perhaps he’ll offer to sell them for $3.75 Each. If you have entered a market order, you’ll pay the market price of $3.75.

Market makers are very intelligent, sly, clever and entrepreneurial. Their job is to make the market, and make money doing it. You do not want to exchanges with the market maker. Similar to Las Vegas, he’ll always win. You are much better off buying an option with a good open interest.

Forex market makers ensure that the marketplace is always functional and that the currencies in it will always fetch the market rate. Forex market makers do so by updating their prices at intervals of at least 30 seconds and undertaking to trade if it’s requested. Forex market makers must fulfill their obligations, regardless of whether the economic situation is favorable or unfavorable, or whether they lose or profit by doing so.

Typical forex market makers include Gain Capital, Forex Capital Markets (FXCM), CMS Forex, and Global Forex Trading, all of which are governed by the Commodity Futures Trading Commission (CFTC) of the USA.  Another prominent forex market maker is Saxo Bank. This is regulated by the Financial Services Authority (FSA) of Denmark.

Open interest is the number of contracts outstanding on XYZ. For example, let’s say that XYZ has an open interest on their March 50 Call of 1, 000. That means that a number of people own 1, 000 contracts they already purchased on XYZ call and currently own it.

Why do you care? It means that people own those particular calls, there might be a certain number of people who’re interested in selling their calls. Perhaps they have already taken money and want out. Perhaps they changed their mind on the underlying stock. It does not matter what his reason is. However, he’ll probably offer to sell it to you for a period of less than the market maker.

To continue our example, the market maker offers to sell the call for $3.75 per contract. If it is 11:00 AM, and the flurry of buying has diminished, the price will probably come back to around $3.00 Or slightly higher. This is a highly liquid market, because many people are buying AND selling. If there is a huge open interest in that option, you’ll probably be in a position to buy it for a period of less than $3.00. You will buy it from someone who wishes to sell it for a period of less than the market maker’s price.

You can check the open interest of a given option when you pull up the option chain. Look for a column titled OI, OpInt, or Open Interest. Looking at the open interest on QQQQ today, I see that an at the money call has an open interest of 35, 831. This would indicate that this is a very liquid option. The bid/ask spread is $1.33 To $1.36. – Very narrow, indeed.

Let’s look at another less liquid example: G (Genpack Limited) shows open interest on their $15, March in the money (ITM) call of 56. There are 56 open contracts already in place. The bid/ask spread on this is $0.80 To $1.25 – a spread of $0.45. Because there are very few people holding this option, you’ll most probably have to exchanges with the market maker. He will only sell a contract to you for $1.25. He will only buy a contract from you for $0.45. There are virtually ‘no other’ sellers out there willing to sell their calls to you for less.

Market makers are whom options traders really trade options with. When you buy an option, you’re really buying directly from market makers who hold an inventory of those options and when you sell options, you’re really selling back to these market makers who want to keep an inventory of those options. Market makers buy and sell options in the exchange, ensuring the liquidity of all options contracts and profit primarily from the bid ask spread that they provide, buying at the bid and merchandising at the ask. They function exactly like used car dealers, buying at lower prices and selling at higher prices. Typically, the more actively traded the options are, the closer the bid ask spread tend to be attributed to competition between market makers, however, in times of extreme volatility where there’s a lot more buying and selling on panic and more than enough business to go around for all market makers, they usually open up the bid ask spread in order to make even more profits. That is why we saw unusually wide bid ask spreads in this recent crisis. Wider bid ask spreads result in larger upfront losses which again depress the already depressed profitability of stock options, owing to the higher extrinsic values.

The higher extrinsic value and wider bid ask spread makes profiting from simple stock options buying extremely difficult and are the most important reasons why amateur options traders fail to make money buying put options in the recent stock market crisis. Conversely, writing options are an extremely profitable way to trade options during a volatile market where extrinsic values are high. Naked writes and Credit Spreads are really the right way to go in a volatile market condition and are what most beginner options traders don’t know about. Selling options instead of buying them turns the table around and creates an extremely profitable position in times of high extrinsic value. Learn more about credit spreads now.

Don’t buy options at market at the market open. The vagaries of the market price and global influences on our market are immense. By the way, this also pertains to any illiquid stocks, also.

Don’t place overnight orders for options. Wait until at least 10:45 AM before you begin to enter your option order to purchase or sell.

Don’t deal in a stock or option where you’re forced to exchanges with the market maker. You will almost always lose.