How a Professional Market Maker Prices Stock Options
As a former market maker on the CBOE I have a unique perspective on how stock options are priced. Survival as a market maker is dependent on making consistently efficient markets - pricing stock options to the $.01 is the skill required for survival.
That doesn’t mean you need to make a market on all strikes $.01 wide like $.10 bid @ $.11 offer --- but you do need your own value, your theoretical value to be priced well enough to avoid getting run over by the massive institutions, funds, endowments, foreign governments, and whoever else.
Most traders look at the markets value (implied value) as the correct market.
Here’s the fallacy that I see shared across blogs, social media channels, and popular news outlets - they believe market makers are the party that control price. Some even suggest that market makers have the influence to control direction too. From a professional perspective, this thinking is incorrect. Market makers in reality are small players in a market dominated by ‘real’ institutional dollars.
Let’s take a step back and think from a common sense point of view.
A market maker is ultimately willing to make a market in any stock option, with the objective of taking out small profits. They do not speculate on direction; in fact, they have no interest at all in the direction of a stock. Market makers trade their portfolios delta neutral. By trading their accounts delta neutral, they take direction out of play and focus on the value of movement, which is referred to as volatility.
They don’t care which way the underlying stock moves; they are concerned with how much or how little it’s moving.
Here’s an example: If a stock historically gyrates back and forth in a huge range but recently has been trading in a tighter trading range, a market maker may ‘skew’ their markets to buy these options rather than selling them. The reason to skew your market in this way would be an expectation that the underlying stock would move as it historically did when it was moving with higher volatility. When a trader buys options (calls or puts) they are buying volatility with the expectation that movement will increase, when a trader sells options (calls or puts) they are placing a bet on lower volatility, or less movement.
To be clear, market makers have zero influence on the direction of an underlying stock. The majority of these Professionals are looking to make good markets, with as much edge as possible and then flip those trades out for quick profits. And now, with the onslaught of automated market makers this proves true more than ever.
Now you may be thinking, if they don’t know direction than how do they value all these options to the penny?
The only indicator used (from my experience) is having a complete understanding of institutional trading activity. Not just understanding these trades, but quickly being able to interpret the intention of these orders.
Here’s another example – if a huge order comes in to buy 12 strike calls when the underlying stock is trading at $10 – many consider this a bullish trade. But, if that massive trade was done while simultaneously selling the underlying stock, that trade is now bearish. Market makers need a quick understanding of synthetic options positions like this: a long call + short stock = long put.
In truth, I’ve never met a market maker who uses technical analysis or any indicator to value options.
Stock options are unique to stocks because all option trades are 100% transparent. For a market maker (or any options trader) seeing the complete story in ‘time and sales’ data is priceless.
Let me walk you through one more example: XYZ stock trades at $10 and XYZ has options traded but the options do not have great liquidity. If 10,000 calls trade on the $12 strike for a price of $.70 – and at the time of the trade the market on that $12 strike was $.20 @ $.70…. market makers will raise their markets on ALL options in XYZ, and when I say ALL options that means all calls and all puts on every strike in every month. That huge trade gives vital information to the trader. For me, my next market on the $12 upside call might be $.60 @ $1.30.
To sum it up, market makers have ZERO influence on the direction of a stock. They can’t manipulate direction or play tricks with pricing. In today’s market they are small fish in a very big pond so let’s not blame these market participants when a trade goes against us because they had nothing to do with it.
This is how option market makers price ALL options.
Jonathan Rose is the owner of ActiveDayTrader.com