The Secret Behind Wall Street’s Bookies
Last week, in the second installment of my “Options 101” series, I touched on a term many people don’t understand…
Today, I’m going to explain it in terms we can all identify with.
The term is “market maker.”
Every time I speak about options trading at an investment conference, at least five or six people ask who is on the other end of the transaction. They want to know who I’m selling to or buying from. It’s a valid question.
The answer whenever you buy or sell an option is the same: a market maker.
Big help, right?
To grasp the concept, you first need to understand that an option on a stock has absolutely nothing to do with the underlying company itself. The company doesn’t create the options nor does it have any control over how many options trade or at what prices.
But someone has to control those things, right?
That someone is the market maker. Market makers are firms that issue options, and they’re usually tied to a major Wall Street brokerage house like J.P. Morgan or Fidelity.
The firms act as a go-between between the buyer and seller. You can think about it like this…
The go-between is basically a bookie. He takes on the risk of an option moving in a particular direction in hopes that he can make a little bit of money each time he’s involved in a trade.
It can be a dangerous game or a very profitable one.
He either hits it out of the park or gets dinged big time. If he gets dinged, he can make it up on volume by getting involved in additional trades to offset the loss. But either way, he’s got to be really smart and nimble… at the same time.
He applies for permission from a given exchange (there are several) to create a market to trade a particular option.
For example, take options on XYZ stock. A market may or may not exist. If it does, he’ll join the other market makers trading XYZ options on that exchange… If it doesn’t, voilà! With a little paperwork, you now have an options market created out of thin air.
Remember, an option is a derivative of an underlying instrument. If the instrument doesn’t exist, then neither can the option.
It’s kind of like betting on a game. If there is no game, there is no bet.
Trade Like a Market Maker
There can be multiple market makers for an option. They are playing against each other and against you.
But what are they playing for?
To make the “spread” between the buyer and seller every minute of every day the market is open.
The spread is created by the simultaneous purchase and sale of options on the same stock, but with a different strike process and/or expiration dates.
Take a stock like IBM (NYSE: IBM) for example. The market maker knows IBM trades a lot of volume. He also knows that there are people who want to bet on IBM’s direction without having to fork out $170-plus per share to buy it.
They are the options buyers or sellers.
Let’s say that the IBM option is trading for $1 on the “bid” but $1.50 on the “ask.” Both are listed in your brokerage account like this…
(The bid price is the highest price the market is offering to buy the underlying stock, and the ask price is the lowest price the market’s offering to sell the underlying stock.)
The spread would be $0.50. So what does the market maker fantasize about each night?
Buying the option from a seller for $1 and selling that same option to a buyer for $1.50.
That’s a 50% gain from one trade. If he can replicate that all day, there’ll be another yacht parked in the harbor pretty soon.
But there’s also some risk…
As the creator of the market, he’s basically creating trading instruments out of thin air. The options pricing model (based on the Black-Scholes formula) I wrote about last week, allows him to create the price.
But he also has to manage the risk. If there are only buyers and no sellers, guess what? He now is selling you something he actually doesn’t have in inventory.
That’s a lot of risk if the stock moves in a direction that’s bad for him.
He has to offset that risk. And he does so by widening the spread so that when the sellers do show up, he offers them a pittance, and the buyers pay a fortune.
If the situation is fluid and there are buyers and sellers, the spread narrows.
Sometimes, he may even have to go out and buy or sell options himself to offset potential risk.
So it can be a very expensive proposition unless you know what you’re doing. And believe me, options market makers are not stupid or lazy.
Ultimately, the market makers are the ones who make sure that the markets operate in a smooth fashion continuously. According to the SEC, they are “firms ready to buy and sell stock on a regular and continuous basis at a publicly quoted price.”
The same is true for the options market. That’s not just an idle definition, it’s a guarantee.
Market making can be very, very profitable. It has to be because the risks are just as large as the rewards.