Q & A. Who buys all those options?

I am an avid follower of your blog and thanks for such a great service you are providing to option newbies.

I have a question regarding covered calls. I hear that so many
folks (including
mutual funds etc) sell covered calls on the stock they own.

Who buys these calls? Is it the hedge funds?  But how do they make money
by doing this unless its a fast bull market? This question has me baffled.

Please enlighten us with this info on your blog?



Hi Jack (I hope no one greets you that way at the airport)

There are so many options trading these days (several billion contracts every year) that there is no single strategy that overwhelms the markets.  No matter how many people want to sell options – covered calls or any other – there are always buyers.

You are correct in that there are a bunch of funds that adopt covered call writing as a strategy, but compared with the total number of mutual funds there are on the market, very few are allowed to use options in any form.

The buyers

Professional market makers are either standing in the trading pits (where the options trade) on the exchange floors, or are represented by computers.  Those market makers continuously show a bid (price they are willing to pay when buying) and ask (price that want to receive when selling).  Thus, there is always a market for your orders (or any orders) that arrive on the trading floor.  These days, orders arrive electronically.

Many orders are filled instantly because the price that the buyer is willing to pay meets, or exceeds the price the seller is asking.  At other times, there is no trade and the seller's offer waits for someone to be willing to pay the price.  No seller is require to settle for the market maker's bid. You may ask any price you choose.  The higher that price, the greater the likelihood that no one will want to buy the calls you have for sale.

Your premise that those buyers want to see a big rally is not accurate.  You must remember that plenty of people sell put options, and the market makers will be overloaded with puts on occasion.  That means the buyers of options don't always want to see a big rally, sometimes they want to see a big decline (when they buy puts).

While it's true that an order to sell a very large number of contracts may go unfilled for awhile, unless the price is lowered, in general buyers and sellers find an agreeable price and the trade is made.

This is true for all options – puts and calls.

So, the question is: how do these buyers make any money.  That's a good question, and most rookies never give it a thought.

1) The option buyers hedge their trades.  They do not take the risk of hoping the market will move in the direction that makes their option portfolio profitable.

2) How do they hedge?  First, the term 'hedge' means: to reduce the risk of owning.  That is normally accomplished by taking on a new position that offsets, or at least partially offsets, the risk of owning the current position.

First they use the Greeks to quantify their risk.  If you are not familiar with 'the Greeks' take a bit of time to learn about them.  For now, let's just say that the Greeks allow the market maker (or anyone else) to evaluate the risk of a specific position with regards to:

  • How much will the trader earn or lose if the stock moves higher or lower (delta)?
  • How much does it cost to own the options (options are wasting assets and decline in value as time passes) (theta)?
  • If the market becomes more (or less) volatile, how much can I expect my option portfolio to gain or lose (vega)?
  • Plus other risk factors

The Greeks allow these market makers to see how much risk they have, and then the traders can decide how much risk to offset (usually the decision is to offset 100%).

They hedge by buying or selling other options and/or shares in the underlying stock.  The goal is to have no market risk.  Instead, they hope to profit by accumulating options at or near the bid price and selling at or near the ask price.  If all goes well and the hedge is truly market neutral, they can prosper.

Complete hedging is a complicated process, and almost all market makers are in partnership with large trading companies who have off-the-trading-floor computers.  The market makers make the trades and then forget about them.  The 'computer' is programmed to find the smartest hedges – once they have a new position.  In fact, the computer manages the portfolio and even makes trades when there is a way to add some edge (profit potential) to the position.

Don't be concerned with the people who buy the options that you, or anyone else sells.  They can take care of themselves.


6 Responses to Q & A. Who buys all those options?

  1. Don 10/18/2009 at 4:01 PM #

    Mark, you say that the MM don’t really care becuase they are happy to get to market nuetral and hedge to 100% But there is something I wondered about MM’s do they ever “read the board” to see what trades are out there or what stops may be on a trade (if this is knowable information) and trade specifically to take out a trade? Also I read about these blockes of options being trades 50,60,70,000) blocks and I was curious how these are traded are they simply bought at the bid? Does a trade table do these trades? Also is pin risk ever manipulated at the close of expiration? I have heard that there are times that a concerted effort to get a stock to a certain number is done but I can’t see that happening.
    Say you bought (for arguments sake) 100 IC’s, would a MM have anyway to exploit or manipulate that trade for their profit at my expense?
    Is the options trading field a level one, or is it tained in some way?
    Thanks, Don

  2. Mark Wolfinger 10/18/2009 at 8:51 PM #

    1) I never said the ‘don’t care.’ Where did you get that idea?
    2) MMs trade to make money. If they do not want to buy any options, or some specific options, all they have to do is make sure their bids are lower than the other bids.
    On the other hand, if they are anxious to buy, they raise their bids.
    They certainly do care about the trades they make.
    If you sell at their bid price or pay the offer, they are very pleased.
    2) Anybody can attempt to read the market if he/she wants to take that risk. When I was trading in the old days, taking a stance on market direction was very common.
    Today, the market makers are no longer independent, as I have already told you. Their trades are monitored by their upstairs partners who offset every trade the market maker gets. Thus, unless the idea is discussed in advance and the whole team is on baord, the floor trader cannot get too long or short. Their partners will neutralize.
    3) Stops are supposed to be secret. I have no idea whether they are. It’s also a terrible idea to have a stop in place for an option. Terrible. It’s far bettter to have a stop in place for the underlying s tock – and that stop would trigggere an option orer. I have discussed this on the blog previously.
    4) I have no idea what a ‘trade table’ is.
    5) Huge orders do not suddenly appear on the option exchange floor. They are shopped off the floor among bigger players to see how much they will pay for the options, and how many they will buy at that price (same applies when a buy order, where sellers are sought). By the time the order arrives in the pit, you can be pretty certain that essentially all of it is accounted for. Sometimes the market makers do not take part in the trade and sometimes they do.
    Don – Think about this. You are trading a stock in the pit and suddenly there is an order to sell 50,000 calls. That’s equivalent to 5 million shares (or less, depending on the option’s delta).
    How anxious is anyone going to be to buy ANY of those calls when you recognize that the call buyers will be scrambling to sell 2, or 3, or perhaps up to 5 million shares? Not very likely.
    Ask yourself this: Why would anyone announce to the market makers all at once – and as a surprise – that there is a seller of a few million shares? And oh, by the way, please pay me a good price for my calls and don’t worry about all the stock that is going to be sold as a result of my order. No one would do that. Thet’s the way to be certain you get a terrible price on the calls for sale.
    Your questions come from somewhere out of left field. I simply don’t understand why you are asking. Are you just speculating on some impossible situation to figure out how it would be handled? Or are you asking about scenarios that think occur all the time? I don’t get it. I truly want to understand.
    6) It is a simple matter for professional traders to get rid of pin risk. They just trade a box, reverse conversion, or conversion – all no risk trades – with each other. That way they eliminate pin risk options from the portfolio.
    Some people believe the action of pinning a stock is possible and as you indicate, a conspiracy. I have never seen such a conspiracy, I was never asked to join in one in all my years on the floor, I know no one who has ever been part of pinning a stock. I do not believe in the conspiracy theory. To me pinning is a hoax, just as is ‘max pain.’
    HOWEVER, if the MMs are long ATM expiring options (puts or calls) then they have lots of gamma. For them to minimize risk and take advantage of that positive gamma, it’s natural to sell stock when it passes the strike and buy it when it dips below. If the open interest among the professional traders is large enough, this natural trading keeps a stock near a strike. In that situation, it is more likely the stock will be pinned. But, not conspiracy in my opinion.
    7) I bought a measly 100 iron condors and you expect some market maker to manipulare a stock that trades millions of shares per day or per week to try to eke out some profit from my measly 100-lot trade.
    I cannot believe this question. Where do you get these ideas/ Please tell me.
    The answer is no.
    8) I believe it’s a fair field. I also know for a fact that some brokers cheat. By that I mean they front-run orders. If they know there is a big call buyer, they buy stock before that order hits the floor. This is a natural way of doing business for some of the unethical firms – whem I cannot mention because thieves don’t like to be called thieves and they would sue.
    This doesn’t happen every minute of the day and night, and if you don’t enter market orders, the game should be fair enough to suit you, or any individual investor.

  3. Don 10/18/2009 at 9:57 PM #

    Mark, thanks for the time to answer these questions. I know that for you and your experience they may seem “out of left field” I ask because I don’t know.
    For example, I see blocks of 30,40 even 50K calls and puts sold at once even in options with only minimal open interest, I wanted to know the mechamism for how this happens for exactly the reason that you stated- how could they get a competitive price under those circumstance? It doesn’t make sense.
    Trading 100IC’s is small change for some people but not for me, and not all of the stocks or exchanges have the same liquidity as the RUT some more, other’s less- I don’t know how it works or if this is even if it was a consideration, so I ask.
    People who are not “in the pits” (like me), or do not have the experience either as a MM or in the inside business hear certain things about “pin risk” “max pain” and other potential manipulations (which you mentioned as front running) I don’t know if these are real or imaginary concerns so I ask. Its clear that some brokers cheat and others don’t, but I am glad that I know now.
    I have heard that big orders go through brokers direct “trade desks” I was curious about that so I wanted to ask.
    These questions may appear to be way out there to you, and I apologize if in any way you feel that this is a waste of your time. If I knew all the anwsers and had all the experience that you have had, I am sure these questions may appear that way as well. I don’t, so I simply ask.

  4. Mark Wolfinger 10/18/2009 at 11:52 PM #

    I get that if you don’t know the answer, you want to ask. But some questions make far more sense than others.
    Wanting to know how a large block gets priced is a good question. Especially when you see that these big blocks do trade. But to ask if you are safe against some MM taking over the stock and moving it’s price to where he wants to see it trade does not make sense to me. Can you move a stock so that it’s price is anywhere you want it to be? If you had 10 billions dollars, how much of it do you think it would take for you to accomplish that goal? Would it be worth that amount to take a profit from a 100-lot iron condor?
    But the real point is this: If some really were sophisticated enough to do that, how would I ever hear abut it? How would anyone? That manipulation is a federal crime and would have to be kept secret. My conclusion is that it’s impossible. But if I am wrong and it is possible, I will never learn the truth.
    Lots of people trade each stock. The stock is not the private plaything of a market maker. Besides, price manipulation is against the law and if it becomes too obvious, even our ignorant SEC may see what’s happening.
    Agree about your not having any floor trading information, but why do people who are learning about options – always believe what they hear? I have spent far too many hours agguing with people about the absurdity of ‘max pain.’ I don’t know why the idea always believed and never doubted. Just because ‘someone told me’ should not be good enough. But it is.
    If a friend told you’options’ is an easy game…and that he just made $300,000 in a month, starting with $2,000. Would you a) believe him and b) think you could do that yourself? Probably not. But when somone says that market makers pin stocks, it’s always believed. Why is that?
    Some brokers cheat, but not in any way that’s going to make a difference to you. Or me (any more). I, and other market makers used to get cheated on a regular basis, but no one ever cared. And the same discusgting firms are still in business.
    I’m sorry. I did not understand that by ‘trade table’ you meant ‘trade desks.’ Yes, the trade desk is the place from which the broker with the large order tries to find big investors to take the other side of the trade. So Trade desk is a good term.
    Does it now make sense now – how they get a decent price for the big trades? The trades are arranged by the time the trade gets to the exchange.
    It does not matter if 100 IC is small change for you. It does not matter at all. You want to know if the MM can manipulate the price of the stock to take a profit from his trade with you. Because the MM doesn’t know you and doesn’t know how much oney you are worth, he has no idea if it’s a big trade or a small trade to you. And why would he care?
    Have you considered the other few hundred thousand options that trade? Are they to be ignored while the MM pushes around the stock price to hurt your 100 lot? You must recognize why that cannot happen. And the MM cannot manipulate the stock. Not one MM and not all of them acting in conceret (a huge violation of security laws).
    I get that you want to learn. So do we all. I was just thinking that some questions cannot be answered. I want to know if elections are rigged and whether the voters really have anything to say. But no matter which questions I ask, there is no one I can ask who has the answers. And those who do have the answers are not going to tell me. That’s why I don’t have the answers to some of the questios you raise. Life is like that. If there is manipulation on the trading floor, I certainly have no way of knowing about it.

  5. don 10/19/2009 at 10:44 AM #

    Mark, makes a lot of sense…Thanks I don’t believe anything that’s said until I have some empirical validation. Because I am having some success in my paper money account I want to explore the ideas that I hear others (many, many others)claim as facts, not from someone else, but from you, a professional with experience.
    Appreaciate it…

  6. Mark Wolfinger 10/19/2009 at 11:46 AM #

    There are other professionals with different experiences.
    While I beleive very sgtrongly that certain things are hoaxes, it does not mean that everyone else agrees with me.
    For example, I cannot prove max pain is a hoax