"Market Makers" questions

[hissho]

hi
i'm very puzzled by the thing called "market makers" and would like to ask for some enlightenment. anyone here who used to work as a MM?

1) it's said that market makers are there to provide liquidity. is it correct? is providing liquidity their only job?

2) are market makers allowed to make money? there's a big difference between "they are allowed to make money if an opportunity presents itself" and "they are trying to make money WHENEVER possible"...

3) how can i tell if a bid-offer spread is put there by the market makers or natually by different bidders and sellers? i mean it's easy to tell when you can't find bid-offer prices---you just call your broker and request a quote--that quote must come from a market maker; but when you see a spread with bid-offer prices and with a very small open interest, for example 5, how can you tell?

4) do market makers do trades with other market makers? Will a market maker be able to tell(using their proprietary software) if a trade comes from another market maker or a private trader?

any help would be greatly appreciated,
hissho

 

[professor_frink]

answers in red mate.

hi
i'm very puzzled by the thing called "market makers" and would like to ask for some enlightenment. anyone here who used to work as a MM?

1) it's said that market makers are there to provide liquidity. is it correct? is providing liquidity their only job?

Yes. No- they are there to make money as well.

2) are market makers allowed to make money? there's a big difference between "they are allowed to make money if an opportunity presents itself" and "they are trying to make money WHENEVER possible"...

see 1)! they are there to make money WHENEVER possible, and considering the spreads they offer, it's pretty well all the time.

3) how can i tell if a bid-offer spread is put there by the market makers or natually by different bidders and sellers? i mean it's easy to tell when you can't find bid-offer prices---you just call your broker and request a quote--that quote must come from a market maker; but when you see a spread with bid-offer prices and with a very small open interest, for example 5, how can you tell?

Normally they are the ones trading in round lot numbers, so if you look at the spread, and 10 on the bid and 10 on the ask, it's quite possibly a MM

4) do market makers do trades with other market makers? Will a market maker be able to tell(using their proprietary software) if a trade comes from another market maker or a private trader?

Probably, but I don't really know.

any help would be greatly appreciated,
hissho

 

[rhmt01]

although market makers have a licence to print money, they do have certain obligations depending on the security.

http://www.asx.com.au/investor/pdf/asx_options_bid_ask_spreads_and_categories.pdf

a short explaination on what market makers do is here

http://www.asx.com.au/investor/options/trading_information/market_makers.htm

however you should make sure that the market makers are fulfilling their obligations. I've had a few problems with market makers offering bad spreads, but I found a quick call to ASX Market Control on 1300 655 560 pointing out the dodgy spread gets the MM's **** kicked pretty quickly. (and reverting back to the 'allowable' spread)

 

[spitrader1]

answers in red mate.

pretty damn close professor. options market makers are there to make money and deal with retail and insto clients. Its a little different in the cash market!!

 

[spitrader1]

pretty damn close professor. options market makers are there to make money and deal with retail and insto clients. Its a little different in the cash market!!

this may also help

https://www.aussiestockforums.com/forums/showthread.php?t=3980

 

[professor_frink]

pretty damn close professor. options market makers are there to make money and deal with retail and insto clients. Its a little different in the cash market!!

Better fill me in on which parts I was a little off on spi- I'll have my professor tag stripped from me by the international professor's association if I'm caught giving out dodgy advice

 

[spitrader1]

Better fill me in on which parts I was a little off on spi- I'll have my professor tag stripped from me by the international professor's association if I'm caught giving out dodgy advice

haha....you werent wrong on any...but i can provide clarification on one issue, of trading with each other. How else would they get access to liquidity when they want to Prop trade (they do this as well as performing there MM job)-----just a hint, most of the banks view the market making department as a way of getting there prop traders reduced ASX fees, not as a primary market making department.

 

[professor_frink]

haha....you werent wrong on any...

Phew... Can keep my title for now

but i can provide clarification on one issue, of trading with each other. How else would they get access to liquidity when they want to Prop trade (they do this as well as performing there MM job)-----just a hint, most of the banks view the market making department as a way of getting there prop traders reduced ASX fees, not as a primary market making department.

that doesn't surprise me at all.

 

[hissho]

Thanks Professor!

just a follow-up question: if MMs are there to make money and do it whenever possible, is there a chance that they could lose money? if they do have a chance of losing money, what could be the cause? maybe because of failing to hedge themselves successfully? but MMs are all perfectly hedged aren't they??...need some more enlightenment

cheers
hissho

 

[hissho]

helloooo professor!

any more help please? I heard MMs all hedge themselves perfectly so i'm wondering how they hedge themselves. and if they are always properly hedged, how can they lose money?

thanks again!
hissho

 

[professor_frink]

helloooo professor!

any more help please? I heard MMs all hedge themselves perfectly so i'm wondering how they hedge themselves. and if they are always properly hedged, how can they lose money?

thanks again!
hissho

Sorry Hissho, completely missed your question-wasn't at the computer last night.
To be honest I couldn't tell you the answer to your question.
At a guess, I would have to say that it's possible for them to lose money-nobody's perfect after all.

 

[spitrader1]

Thanks Professor!

just a follow-up question: if MMs are there to make money and do it whenever possible, is there a chance that they could lose money? if they do have a chance of losing money, what could be the cause? maybe because of failing to hedge themselves successfully? but MMs are all perfectly hedged aren't they??...need some more enlightenment

cheers
hissho

hissho, there is no such thing as a perfect hedge. even if a MM hedges there delta, they still have interest rate risk, divindend risk, volatility risk, without even getting into the second derivatives like gamma. Of course MM's can loose money. THats why only the good ones last. And dont forget, as ive already said, to most of the MM's, making markets is a secondary feature to there real role, which is derivative prop trading.

 

[Magdoran]

hi
i'm very puzzled by the thing called "market makers" and would like to ask for some enlightenment. anyone here who used to work as a MM?

1) it's said that market makers are there to provide liquidity. is it correct? is providing liquidity their only job?

2) are market makers allowed to make money? there's a big difference between "they are allowed to make money if an opportunity presents itself" and "they are trying to make money WHENEVER possible"...

3) how can i tell if a bid-offer spread is put there by the market makers or natually by different bidders and sellers? i mean it's easy to tell when you can't find bid-offer prices---you just call your broker and request a quote--that quote must come from a market maker; but when you see a spread with bid-offer prices and with a very small open interest, for example 5, how can you tell?

4) do market makers do trades with other market makers? Will a market maker be able to tell(using their proprietary software) if a trade comes from another market maker or a private trader?

any help would be greatly appreciated,
hissho

Hello hissho,


In addition to the comments made on this thread, I’ll try to offer some additional information for you to consider.

Think about how an options market works. For a transaction to happen, two parties must take opposite sides of the contract for a trade to occur (we all know the basic definitions for calls and puts, don’t we?).

Liquidity in Options Markets:

How is this achieved? In order to ensure liquidity, exchanges grant market making licenses to trading organisations which fulfil certain requirements to be appointed, and carries a range of obligations contractually with the exchange.

This requirement varies between exchanges, but essentially requires a market maker to maintain a bid and an ask of a certain size (amount of available contracts) within a range of strikes from the current price, and with restrictions on how wide the spread can be from the bid to the ask.

How do MM’s Hedge?

So, how do market maker’s hedge? When you buy a call from a market maker, the market maker may hedge by buying some stock in the market. How much stock they buy will depend on their risk policies. If you buy an ATM (at the money) call, they may only buy around 500 units of stock (assuming Australian 1000 shares per contract) since the delta will probably be around 50% (the option will move 5 cents to a 10 cent move in the underlying).

If you bought an OTM (out of the money) call with a 30% delta, they may only buy 300 units of stock to hedge for example. But as spitrader1 points out they are still at risk with interest rates and volatility shifts, but they can hedge these two in a number of ways using structured financial products, futures, bonds, etc.

The way market makers deal with dividends is generally to adjust the volatility levels, reducing the volatility of call values incrementally as they near exdiv (and resetting post exdiv to normal), and increasing the volatility proportionally as they near exdiv (again resetting post exdiv).

On any given trading day, a good market maker usually has an algorithm set up to take into account the entire aggregated effect of long calls, short calls, long puts, short puts, and long/short stock they are holding, at different strike levels and different expiry times. They can adjust the theoretical exposure to be as nearly hedged as possible, or can adopt a policy direction if they have a market view and be skewed either long or short the stock based on the configuration of the overall positions.

Think about how a bookie works when taking bets on two football teams. They may offer $8 return to a $10 bet to win in a 50/50 game. They are hedged if one person bets these odds on team A, and another person bets on team “B”. They take $2 profit, and can’t lose. They pay the winner their original $10 back, plus the $8 win, and keep the $10 form the loser, making $2 profit. This is how market makers with options aim to profit from the bid and ask spread.

Of course giving odds in a horse race is more complex, and a little more like the options market. If someone buys 10 ATM put contracts, and you buy 10 ATM call contracts, of the same stock at the same time, these can essentially reduce the risks as the stock moves.

Think about how bookies work at the racetrack by offering odds. Market makers work in a similar way to make money, generally by pushing the buy price higher than fair value based on the current price of the underlying, and the current volatility levels, and the same for the sell price – pushing it lower.

Different market makers can be making a market for the same options series, and you can find one is offering the bid, and the other is offering the ask, with each others other side being further out than the other. This effectively reduces the spread when it happens. A lot depends on how aggressive a market maker is, and what kind of policy they adopt in terms of exposure.

It is entirely possible for one market maker to trade with another (just like a bookie does) to hedge risk. Think about a bookie that takes two bets on a 100-1 odd horse. They may make one bet with another bookie to reduce their exposure. The same is true for Market makers. They may transact with anyone in order to hedge a position. It is more likely that they will look to do this using shares though.

The market maker’s aim is to make as much margin on each transaction as possible– if you are offering a trade which hedges another trade on the opposite side, you may get set around fair value or better, especially if there is a lot of activity on the other side of the market (i.e you’re entering bullishly while the majority are taking bearish action). But if you’re exiting on stop, and they see you coming, they may widen the spread, or skew it as people get shaken out of positions. This is partly how they can maximise their profits.

Another thing to think about is that in less liquid stocks, your transaction size will be based on the availability of stock. For instance, if buying puts, the market maker will try to sell a corresponding amount of stocks in the market, hence they will be looking at the available shares on the bid to hedge, depending on the expiry date and where the strike is (ITM, ATM, OTM).

So, if you’re looking to buy 10 ATM put contracts, and only 2500 shares are available on the bid, they may only transact 5 contracts at that point, if the theoretical margin is sufficient. If not they may not transact with you at all. Just keep this in mind when you get a partial fill.

The availability of shares to hedge the opposite side may be a determining factor of where you will get set if there isn’t any activity in other options. Also, if others are looking to take a similar position to yours, but at a different strike, this may reduce the available shares to hedge too. The more players, the more difficult it is for you to monitor. Hence you can get set at some amazing prices if you work out the plays for the whole range of options and stock…

I hope that gives you all food for thought!


Regards


Magdoran

P.S. Margaret, this may illustrate some of my thinking about how to play the market makers that you have been asking me… hope it helps. Mag

 

[Bobby]

But if you’re exiting on stop, and they see you coming, they may widen the spread, or skew it as people get shaken out of positions. This is partly how they can maximise their profits.


Magdoran your whole post was very good !

With reference to the above, would you say using stops with CFDs ( MM ) is like showing them your hand (cards) each time you play ?

Bob.

 

[Magdoran]

But if you’re exiting on stop, and they see you coming, they may widen the spread, or skew it as people get shaken out of positions. This is partly how they can maximise their profits.


Magdoran your whole post was very good !

With reference to the above, would you say using stops with CFDs ( MM ) is like showing them your hand (cards) each time you play ?

Bob.

Absolutely.

“Knowledge is power”

In a game where money is at stake, you really have to consider the greed equation of human nature, and think every avenue through thoroughly from an historical perspective of the ingenious ways people aim to accumulate wealth, either legitimately or not…


Magdoran

 

[wayneL]

Just like to add, from my understanding, the most common MM hedges (in the options markets) are the conversion and the reversal; locking in an arbitrage profit.

That's not to say they won't take on some risk via the combos' that Mag mentioned, or indeed other spreads ('flys etc), but that is the most common

 

[Magdoran]

The way market makers deal with dividends is generally to adjust the volatility levels, reducing the volatility of call values incrementally as they near exdiv (and resetting post exdiv to normal), and increasing the volatility proportionally as they near exdiv (again resetting post exdiv).

Errata

This comment should have read:

“and increasing the volatility proportionally of puts as they near exdiv (again resetting post exdiv).”

Additional comments about the Australian Options Market:

Also, a point I neglected to address is what market makers see. My broker used to be able to tell me who was in the bid and ask, and I could know if it was a market maker like Timberhill, Optiva, Susquehanna etc, or a retail broker (and which broker), and the size of their order.

For some reason this was withdrawn, so I can’t do this anymore (really hate that – it’s like flying blind now). So I’m not sure if the market makers can still see who’s order is in the system. I suspect that they still can, but I don’t know (anyone???). But they have a very good idea about who’d playing in the market, and in part they can tell a lot about how you handle your order.

If you jiggle your order up and down, they’ll smell an amateur if their operator is awake, and they may play spread games with you widening the spread, enticing you to enter at a less favourable level, even if the underlying does nothing at all. Beware of this, this is a standard market maker trick. I found you really have to have an approach in mind (almost a preconceived tactic) based on your view of the underlying and what it will do.

A lot depends on the strategy you are entering/exiting, and the time frame you have in mind, and the level of profit you are looking for. If you’re scalping, this is radically different to position trading. I’m a position trader, so my style is not suitable for a scalper/intra-day trader.

Tactics:

Ok, I’ll make some general comments about a directional style, with a focus on basic options positions positions. Spreads can require some other angles such as skews etc, but I won’t focus on this here.

Basically the idea is to know in advance which tactic to employ for the situation ahead of time. Also, it’s like being a boxer in training – you have to study and perfect your moves. Develop your own style, and keep your flexibility up (mental in this case), and psychology in good shape too. I’ll just outline the basics, but be aware that there are many facets to this, and that these examples are at the basic level. There is much more to this.

Tactics: (a) You can just take the bid or ask decisively if you think the value is good, and you’re expecting a significant move, so just pay up and be done with it, follow your entry rules. (b) Enter just over the middle of the spread. (c) Enter an order at the level you think will be just inside the best price for the day based on your projections and leave it – especially if your position can be entered over a couple of days time, and you can pay up a bit later.

Generally if you’re expecting a move that day, just get set. If you think you have time to get a good price, try to enter on a suitable day. If going long an option like buying a call for instance, look for the underlying to mark time for a couple of days looking for volatility to drop a few points, then enter later with less theta decay. If you see a reversal day (depending on the whole pattern), it may pay to wait a couple of days for the volatility to abate, since market makers often inflate the price on obvious pivots.

If you’re selling, you want to sell when the premium is high in terms of volatility usually in the opposite direction to where you think the underlying is going to go. You want to sell on a volatile day. Hence you have to time it right to maximise the premium. Best time is to sell into a frenzy when the demand is high. As you can imagine there is an art to this. (By the way, I don’t sell naked – this is highly risky, up to you if you have sufficient funds or stock etc – I tend to use spreads to cap the risk – it’s a personal choice though).

If you think the underlying is turning hard and quickly, sometimes it pays to just be decisive and get in (or out). You have to be the judge of this…

Think about it this way. The “slippage” is a cost of doing business. The market makers provide a necessary service in ensuring liquidity, and they have to make a living. You have to pay the piper. If they don’t get to eat, there couldn’t be an options market. So don’t begrudge them a reasonable bite. Do avoid over paying them, unless it is to your benefit. Only pay up or accept a lower price when necessary, either to secure a significant move, or to avoid a significant loss, or to secure the lion's share of a profitable trade. This is where experience is important.


Regards


Magdoran

 

[Bobby]

Absolutely.

“Knowledge is power”

In a game where money is at stake, you really have to consider the greed equation of human nature, and think every avenue through thoroughly from an historical perspective of the ingenious ways people aim to accumulate wealth, either legitimately or not…


Magdoran

Gee Mag , the MMs must just love the dopes that set stops.

Yes Knowlegde is power ,.

I remember Henry Kissinger's womanizing , although Henry physical looks were at best crook, he did have a knack of pulling young pretty females who loved his Power above his looks.

Regards
Bob.

 

[wayneL]

If you jiggle your order up and down, they’ll smell an amateur if their operator is awake, and they may play spread games with you widening the spread, enticing you to enter at a less favourable level, even if the underlying does nothing at all. Beware of this, this is a standard market maker trick. I found you really have to have an approach in mind (almost a preconceived tactic) based on your view of the underlying and what it will do.

Haha yes! MM games are legendary stuff; good for hours of amusement if you know how they think. Cat & Mouse!

The fun part is in deciding who is the cat and who is the mouse. LOL

 

[Bobby]

Haha yes! MM games are legendary stuff; good for hours of amusement if you know how they think. Cat & Mouse!

The fun part is in deciding who is the cat and who is the mouse. LOL

This intrigues me, wonder if there is a pendulous strategy to play the mouse in disguise ?