Making Markets in Options
Many people envy the
bookmaker at the race track, but rarely does anyone give them a thought when
the favorites keep winning. So it is with the market makers who seemingly never
cease to quote a price.
Market making involves
considerable funding abilities. Not only will a clearer demand that margins be
funded, but option traders are unfortunately still plagued with many
administrative decisions going against the grain of common sense. It is not
uncommon for up to 25% of the available funds to be required to remain idle and
free of margin commitment. Even if the position in total has very small risk,
the number of open positions alone will be margined individually with only a
ceremonial discount will be extended in lieu of offsets.
The role of a market
maker is to provide all and sundry with the opportunity to participate in the
market. For this privilege participants will pay a price, and that will invariably
be in favor of the price maker. As in most asset
allocation, the expense of crossing a spread to enter and exit a position is
often the one silent expense that balances against other advantages such as low
fees, leverage, and even liquidity. The market maker is
not concerned as to what option they are trading, it is the price that an
option trades at that is focused upon. Needless to say, every position is
hedged immediately, as primarily the market maker is a volatility trader, but
one who offsets one position with another, building a portfolio of option
positions that is founded on theoretical value.
If a benchmark is
provided by the pricing model, and allowances for the nuances of supply and
demand are incorporated, a market maker can price any option using a
combination of these sometimes competing interests, and take advantage of
value. In an uncertain world, theoretical value that is mollified by the rigor
of the real world is as close to precise valuation that a human being can get. When
a market maker’s price is accepted, if care has been taken in pricing, value is
undeniably present.
Of course, part of the
market makers task involves adjusting their prices according to the forces of
demand and supply at the time; it makes little sense to offer what is a certain
buyer, a price that is unreflective of this pertinent knowledge. Accordingly,
the benchmark volatility may need to be revised upward if there is pressure
from buyers at the time, and conversely if sellers are predominant. In the
fullness of time, the market maker will be accepted on the other leg of their
price, and so again capture value. It is not the precise values that are of
import but the process of quoting prices. If value is achieved in every trade,
profit will accrue, and it is upon this principle that the livelihood of the market
maker is hinged.
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