Trading Like a Market Maker. Q and A.

Hi Mark

I really love these articles as I have now spent
two years learning the basics of options and you know that your book
has saved me a lot.

Today's column reminded me of some other comments that I see on the
blog and other web places and that is: how do the pro's make money?

For example, you were a market maker for 20+ years, there is no way
that I will have that experience or exposure, how do the pro's manage
their money?

I see that there are things like Gamma Scalping, Trading Vega,
adding more Vega into positions, Delta Neutral and other like ideas, in
addition to factoring in IV. How would a MM look at these issues, how
do they maintain or ensure profitability with the complexities that
they have to deal with.

Where should the focus be in this complex mix of IV, Gamma, Delta,
Theta that all interact with each other and interact with each other
differently dependent upon how other factors come into play. Are these
ideas when executed profitable? or, are they parts of the trading
strategies.

By the way I have spent a lot of time in your book reading about synthetic positions and those explanations have really helped.

Thanks,
Don

***

Hi Don,

Understanding synthetics is very important – if you want to understand how options work.  I recommend it for everyone.  A rookie trader can get by without grasping this concept, but it does place him/her at a disadvantage.

Regarding the market makers:  Today's environment is very different from the situation when I left the trading floor in mid-2000.  Very few option traders are independent.  They all work for much larger trading firms.  They make trades on the floor, and then ignore those trades because the off-the-floor partners hedge the positions to eliminate as much risk as possible.

How do they make money?  They buy and sell at favorable prices (buy bid, sell offer), and then their partner, the trading company programs its computers to 'know' how to eliminate all risk (vega, theta, gamma, delta, plus others) across a universe of stocks and indexes.  Those favorable prices, or 'edge,' eventually translate into cash as positions are closed – either at expiration or earlier.

How do they manage money:  very carefully.  Risk has become an anathema.

Gamma scalping and delta neutral trading go together, and can be used by retail traders.  When a position has positive gamma, as the stock moves higher, the trader gets longer because deltas are accumulating.  Similarly, as the stock declines, the trader gets shorter.  Every so often, the trader sells stock on rallies (enough to make the position delta neutral) and buys stock on dips – again to get delta neutral.  When the market behaves and moves higher and lower – by enough so that the trader gets to buy and sell – the trader offsets the daily time decay with profitable scalping.  If the move is unidirectional and the trader sells, sells again, and sells again, he/she is near neutral all the way, and there's probably little money to be made.

You can gamma scalp and trade delta neutral, but it requires positive gamma and a willingness to own a backspread.

Vega is added to positions any time the market maker (or his partners) decides to own vega.  But, these days, it's much safer to be neutral everything.  To add vega, they simply buy options.  They choose the month in which they want vega.  Probably also ITM, ATM, or OTM.  They can develop any position they want to hold.  It's not difficult – especially when the upstairs computers can enter orders and buy at the bid price.  These trading firms can do that because it's possible to be an off-the-floor market maker and participate via computer.  It's no longer necessary to stand on the floor in the trading pits. 

It may sound complicated, but it isn't overwhelming.  The head trader inputs targets (neutral everything, or perhaps long 2% vega, etc) and the computer sets bids and ask prices to accomplish what's needed:  Bid higher when looking to buy, ask less when selling.

You have neither the computer power nor the ability to buy on bids.  Nor can you monitor a position as closely as necessary.  So your choices are limited.  You can adjust to delta neutral whenever it suits you.  You can focus on any specific risk factor that suits your comfort zone.  You can trade long or short gamma, vega, theta.  But trying to put all of them together into one macro strategy is beyond your ability.  Not because it's you, Don.  But because it takes many trades to get precisely what you want.  And then the Greeks will change and you'll want to adjust again.  That's not for a retail customer. 

I prefer to keep it simple and not try to compete with the market makers.  There's room for everyone in the options world and I recommend that you find your niche and trade within it – until it's time to find a new niche.

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2 Responses to Trading Like a Market Maker. Q and A.

  1. marathonman 06/13/2009 at 9:26 PM #

    Mark,
    Than was a fantastic “real life” explanation about questions that I have had for a while. It’s challenging, Renaissance Technologies is a mile or so from here and I keep wondering how I could possibly compete with these quant guys who average 30% year (RE: Jim Simmons) actually makes it understandable why people invest with others. Time, computing power and technological and man power advantages.
    But reading your answer seems to give me hope, I am really working on getting my own “feel” for the market and then implementing the strategies you mention in your book.
    Thanks for taking the time to answer so completely.
    I feel that the blog just keeps getting better!
    Don

  2. Mark Wolfinger 06/14/2009 at 10:10 AM #

    Don,
    Glad to hear replies are helpful. that’s the goal.
    Please tell others to visit the blog.