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

3 Responses to Options Pricing: How are bid/ask prices determined?

  1. Don 02/18/2010 at 5:33 PM #

    Mark,
    If a trader expects volatility to rise in a particular stock then IC’s are not as effective as a double diaganol- correct? I am interested in this concept and trading idea- Often (take AAPL its current IV is about 30) stocks IV can be expected to rise in a certain time frame- say three months from now they have a announcement or earnings or some stimuli-IV is expected to increase moving towards that time. To incorporate this information and use an increase in the IV to our advantage would you use the DD and if you consider IV to be high (at a different time frame) would you then sell the IC- (noting that IV is high for a reason) is this a generalized description of a stratagy that you may use? If not what do you consider the risks/downside- Thanks

  2. Mark Wolfinger 02/18/2010 at 6:21 PM #

    The idea is sound. Sometimes there are additional considerations.
    1) Yes. If you anticipate a rising IV, then it’s better to own the DD than the IC
    2) If you expect AAPL – or any stock – to have a significantly higher IV in three months – say the May options, then you want to buy some of those May options when the begin trading after expiration.
    Problems:
    a) If that’s an earnings announcement month, then you are not the only person who know that. Others will be buying May options in anticipation. Thus, be careful to know the IV you are paying before blindly buying them
    b) I assume you don’t want to be a naked May option holder, so you must find a hedge, while calmly waiting to sell those options at an elevated IV.
    Whichever hedge you choose, there’s an opportunity for profit or loss. Thus, holding those May options can give you additional opportunity to profit. However, they may turn out to be costly to hold.
    3) If your primary reason to own the May options is the ability to profit later, you want to find some positive theta trade that compensates you for holding onto those May options for almost three months. Finding the trades is easy – making them profitable is another matter.
    4) I don’t know what I would use to hold the May options. Yes, the DD is a reasonable choice, but it is a negative gamma trade and subject to loss with a big move. My point is that there is always risk when seeking profits. Make your best guess and make an attempt to minimize risk.
    5) If I held the DD and May IV increased, I’d have two choices. First: Exit and take the profits; Second: Sell the May options and covert that DD into an IC. In other words, sell the time spread (which would probably be May/Apr.
    Hope it works for upu.

  3. jacob 03/04/2010 at 1:15 PM #

    Thanks Mark. Great explanation.