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Options Pricing: How are bid/ask prices determined?

Hi Mark,

I have a question you might be able to answer,
especially considering your experience as a market maker. I'm trying to
understand where implied volatility specifically comes from. I've
become unintentionally engaged in an argument with a fellow who insists
that option prices are only indirectly and slightly affected by supply
and demand factors, and more by theoretical pricing models.

My understanding is that one of the crucial inputs to those models
is implied volatility, which is largely affected by supply and demand
factors. This is why a decline following a range bound or uptrending
market can send option prices shooting up, is it not?

Buyers are
looking for protection and sellers are demanding higher premium to
hedge their own risk or profit from the fear of others. This other
fellow insists that prices are only going up because market makers are
doing calculations to determine probabilities and coolly pricing in
higher estimated volatility in the underlying. But if the decline is
recent, I don't see how it would be enough to affect probability
calculations so much.

I realize there are theoretically unlimited options contracts that
can be sold, and so supply and demand would appear to be irrelevant,
but there is still a supply of sellers and the demand of buyers. Am I
just being naive, and are prices in large part determined simply based
on historical volatility and statistical probability, or are market
makers using the models simply as a guide and also raising prices to
take advantage of a glut of buyers, and lowering prices to find more
demand?

Thanks so much, and I'm looking forward to reading Expiring Monthly once it comes out!

Best regards,

Jacob

***

This is truly a good question, and I don't believe either of you is 100% correct or 100% wrong.

My experience as a market maker is not going to be useful here. We moved option prices up and down by shouting new quotes to people who were typing as quickly as they could – one option at a time.  One option at a time!  By the time we finished, it was time to begin again.  And we did that for three stocks simultaneously. 

Today quotes are handled by computer and all option prices change simultaneously, based on the input that drives prices.  That input obviously includes the stock price and the IV established by whoever is disseminating quotes.


Debate: Option prices depend on supply and demand

From a market maker perspective:

Pro:

If I sell 50 calls, I'm raising the price.  If buyers continue to buy that same option, I'm raising the price again.

I am now short calls, so I'm inching up the prices of all calls.

Because puts are really calls (just buy 100 shares per put and you have a synthetic call), I want to buy those also, so I'm raising put prices).

By definition, when I'm raising prices of all options, the implied volatility is rising.


Con: 

When I see people are buying options and paying the asking price (or near the asking price), I have to attract sellers or else I'm going to be selling too many options and taking on too much risk.

To attract those sellers, I'll just raise the IV that I input into the computer that generates my bid/ask quotes.  That will raise prices and hopefully attract sellers.

Similarly, when I see too many sellers, I try to attract buyers by lowering the implied volatility of the options.


To me, there is no significant difference between these two ideas.  The difference is in perspective and how the viewer sees the situation.  [Is the glass half full or half empty?].

The above is a gross oversimplification.  There are many market makers who trade options in big size (thousands per trade).  It takes significant volume before option prices change (assuming stock price remains the same). These options are also traded on multiple exchanges.  If I, as a market maker, raise my bid and ask prices, no one will buy from me because others are offering at a lower price.  Thus, it's only when the primary market maker has control and can arrange for everyone to raise the bid/ask prices at the same time, that prices move up with demand.  If someone stubbornly sells more and more options at the same price, no one can force that market maker to come to his/her senses and raise the price.

Warning:  I have been off the floor since 2000 and don't know the exact method used to issue quotes when market makers are competing.  But the above is how I assume it works, based on how it used to work.  If anyone currently on the floor cares to provide a better description, please do so.

***

"But if the decline is
recent, I don't see how it would be enough to affect probability
calculations so much."

When IV changes, delta changes.  Thus 'probabilities' change.  It's all interconnected

***

The fact that there is theoretically unlimited number of option contracts that can be written does not mean they will be written when needed – and that's when buyers are present and demanding to buy options NOW.

That is not relevant to option pricing.  It's a willingness to sell right now that determines supply.  It's not the fact that someone who owns 10,000,000 shares may decide to sell 100,000 contracts at some unknown time in the future.

Likewise historical volatility plays no role.  Sure, HV was considered when the MMs first estimated the future volatility for the stock – and thus established option prices.  But once trading begins, history no longer matters to the floor traders.  They want to maintain Greek-neutral portfolios and adjust bids and offers to help them achieve that neutrality.

As an individual trader, you can trade based on your believe that current IV is too high or too low – by taking a + or – vega position.  You plan to hold and see how the trade develops.  Market makers tend not to take that risk and use current IV as the best possible estimate of future volatility.  They base their trading on the Greeks generated by that IV.

I cannot tell you how the markets makers behave.  But I will say this:  Refusing to raise prices when there is a 'glut' of buyers is just being stupid.  Dropping prices when everyone wants to sell is the right thing to do.

When buyers arrive at the stock exchange and the specialist raises prices, no one objects.  Rising stock prices is apparently good for the world.  But if an options market maker raises prices, he is deemed a fiend and a cheat.  Nonsense.

Supply and demand plays a role.  But if you prefer to say that IV is being raised in an effort to dampen that demand, it's really the same thing.

617

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Will There be Live Trades at Options for Rookies?

Normal – options related – blogging returns tomorrow.

Thanks for bearing with me during my dilemma.


Due to numerous requests, I've been considering using Options for Rookies to post, and then follow, a specific, simulated trade.  I will not trade the position in my real account).  This is the plan:

  • Post a trade, with rationale for making the trade
  • Post periodic updates, as needed – if the position remains unchanged
  • Discuss any interesting aspect of the trade.  I anticipate that most of the discussion will involve adjustment or exit decisions
  • Readers comments are an essential part of this exercise – especially when you don't like an action I took (or decided not to take)
    • My recommendations should not be considered as gospel

    • Alternatives should be discussed.  Please fell free to express your thoughts

    • We each have a different comfort zone and that means the same position would be handled differently by other traders

    • If you don't participate in the discussion, it becomes less of a learning experience for rookies



I repeat: The purpose of the exercise is to provide an educational experience for readers.  It is NOT to suggest a profitable trading opportunity for you. 

That's the truth.  Please believe it. I suspect that no matter how often I repeat that sentence, there are those who will make the trade in their own accounts, seeking profits.

No records will be kept of profits and losses.  When the primary objective of a trade is to turn it into a lesson (when feasible), then earning a profit becomes secondary.  I don't plan to lose money on purpose, nor do I intend to take extra risk just because the trades are imaginary.  However, the need to have a winner is not as strong when an important lesson can be taught in lieu of grabbing a quick profit.

The primary purpose of these trading examples is to make it easier for rookies to think about, and understand how certain trading decisions are made.  Or least how I would make them.  If you participate, we all get to see how you would handle specific positions. Feel free to criticize. 

***

That's the plan.

However,  I don't have time to add additional features to this blog.  I love writing Options for Rookies and communicating with readers, but have run out of hours in the day – as discussed three days ago.  I requested reader input and received some very welcome suggestions.

The readers who responded to the poll were split evenly.  The question was whether you would be willing to pay a small monthly subscription to have access to an additional blog.  Although 'no' received the most votes, there were two categories of 'yes' votes, plus another that represents an unhappy 'yes." 

The response convinces me that there is more than enough interest to make a premium blog viable.

There are no immediate plans to make changes.  It takes time to get a new blog up and running – especially when no content has been prepared.

Thus, for the moment, there will be no changes at Options for Rookies, and I will do my best to keep up with questions.   

Planning for an additional blog is ongoing.

607

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Trade update

To complete the iron condor, I sold the RUT Nov 750/760 call spread, collecting $1.25.

The resulting iron condor is: RUT Nov 620/630 put; 750/760 call.
Running net credit: $4.05

I would have preferred not to sell calls with a 750 strike, but it was either sell that spread or collect a very low premium with higher strikes.  This trade fits within my comfort zone, but barely.

118

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Trade Update Notice

Earlier today, Oct 2, 2008, I covered the call portion of my current November RUT iron condor. Paid $0.35 for the Nov 810/820 call spread.  That leaves me short the Nov 620/630 put spread. 

Total remaining credit: $2.80.

With RUT' closing at 637+ today, the index has declined by 100 points since I opened the position.  That's a big move!

There was no call spread that I wanted to sell as a hedge against the puts.  If the market declines again, I'll be forced to reduce, or close the position.  On a rally, I'll have three choices: find a call spread to sell, buy in the put spread, or hold as if I still owned the whole iron condor.

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Adjustment

It's time to take the loss in the Oct 650/660; 780/790 October RUT iron condor.

I'll post results as soon as I can.  With RUT trading at 670, it's too risky to hold – as an experimental trade with a profit capped near $1.00 per spread.

More later.

10 minutes later.  I may have panicked, but that's how I survive over the long-term.  Paid $4.50 to close.  That's a loss of $1.55 and about 25 cents over my maximum loss for this position.  The market certainly fell quickly and down 500 down points and 39 RUT points did not help.

If this were NOT an experimental short-term iron condor, I would still be holding.  In fact, My 'get out' point would have been when RUT reached 660 (the strike price of my short).  But what's done is done and I can easily live to play again as the rest of my portfolio is holding up well (due to owning some extra calls and puts).

The reason I closed:  When the profit level is predetermined, and thus, limited (approximately $1.00), then that reduces the amount I'm willing to lose in an attempt to earn that profit.  When I can earn more – by holding longer – I can take the chance of losing more money.  Risk/reward is an important consideration.  I don't have iron clad rules regarding that ratio, but when the gain is limited to one dollar, I'm not willing to risk losing $4 to earn that profit.

Later again.  I don't like the loss, but I feel much better being out of this near-term, risky iron condor position.

109

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Position Update Sep 25, 2008

I've opened two positions for discussion purposes only.The first is an experimental iron condor.  The idea was to hold for two weeks (that's tomorrow) or perhaps a day or two longer; take a quick profit near 15% of the margin requirement, and close the position to eliminate all remaining risk.

The second is a longer-term (12 week) iron condor.  This position has been held for four weeks.

October iron condor:

RUT was 723. Sold the Oct 650/660 put; 780/790 iron condor @ $2.95.  Goal: Cover by paying $1.90, on 9/26/2008 

Today RUT is 707 (11:15 AM CDT). With IV much higher now (RVX = 37), this iron condor is priced much higher than I had hoped.  The mid-point between the bid and ask is currently $2.85.  The passage of time has helped, but the premium is too high.  Decision: Hold.  I could take a tiny profit to eliminate risk, but with both short options being 60 points out of the money, I believe this position is worth holding.  But, I will be checking every day for an opportunity to exit the trade.


November iron condor
:


RUT was 738. Bought
RUT Nov 620/630; 810/820 iron condor @ $3.15 credit.

With RUT near 707, the mid-point between the bid and ask is currently $2.75.  Decision: Hold. 

106

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No Adjustments

With the market opening +450 (corrected in update) and now up less than 300, I'm swamped with trading.

Just a note to those readers who are following our two open iron condor positions:  no adjustments were made in either the down market (it seems so long ago that the market was down, yet it was only 2 days ago) or the recent 900 point surge.

I'll update with details when I can. 

Update: (above numbers adjusted with update)

The November iron condor is offered at $3.80 and there is no reason to cover this one.  the options are still fairly far OTM and we have held this trade for three weeks.

The experimental (hoping to be able to close the position in two weeks) October iron condor has been endangered – first on the put side and now on the call side.  But, one week has passed, the position is losing money, but has not yet reached the danger zone (at least my danger zone – I assume each of you has his/her own comfort zone). 

This morning was frightening.  Bid/ask spreads were so wide that trading was almost impossible.  It's fortunate that we were not faced with what would have been a difficult trading situation – trying to close a position in the face of panic (upside panic this time).

96

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Considering an Adjustment

The experimental trade for October expiration in running into trouble.  As I write this, RUT is 678 and the the put spread (RUT Oct 660/650)* is only 18 points out of the money.

*Thanks to KC for the correction.

I would consider buying back the call spread (RUT Oct 750/760) and rolling down to a lower strike, but when IV is high (RVX is 38) and the markets are wider than usual, this is not easy to accomplish at a favorable price – that means I cannot collect enough cash to make the trade worthwhile.

Why?  Because the additional cash does little to protect the downside – and that's where the risk lies right now, and because that trade injects upside risk into the position – if the market suddenly reverses direction.  I don't mind being unable to do this because it's my least favorite type of adjustment for an iron condor.


For now, I'm holding this position.  The midpoint between the bid and ask prices for the iron condor is $3.75.  We're losing money but are not yet at the point of reaching our maximum acceptable loss for the position.

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