Why does everyone hate the market makers?

Market makers serve a purpose. It may not be as honorable a of profession as being a surgeon or teacher, but they take a lot of abuse from individuals who trade options. I’m sure some complains are justified, but there is no reason to blame the market makers every time something goes wrong with a trade.

What bothers me most about such accusations is that they come from people who do not understand and have made no effort to understand. They don’t recognize the special circumstances of the vehicles they are trading (a huge mistake), then don’t understand the risk involved in a trade, and then seem to expect market makers to toss cash in the trash, just to satisfy the unreasonable demands of a customer.

Example

There are still traders who buy and sell VIX options with no idea of what they are trading. Then when something goes wrong, they love to blame the market makers for cheating them. If these traders would simply read the rules, or ask questions of their brokers, there would be no problems. Instead they love to trade first and then find someone to blame. It’s the same for Europeans style index options. Many customers have no idea that these options are European style. Worse than that, they never bother to understand how the final settlement price is calculated. What they do very well is complain bitterly.

I trust that all readers here know that VIX options are different from other options. The underlying asset is NOT the spot VIX index. It is a VIX futures contract. And to make it more complicated, you cannot assume which contract is the underlying for a specific VIX expiration cycle. Care must be taken to learn which futures contract underlies the options that you plan to trade.

As if that were not sufficiently complicated, VIX options are European style and cannot be exercised prior to expiration. This is not a product for the under-educated trader. Yet many option rookies go out and trade these options and lose money – just because of ignorance. Do they accept the blame? Of course not. It must be the market makers who are cheating them.

Example

On a forum run by one of the discount brokers, a poster complained that market makers ‘manipulate’ the prices of options, and that he, the intelligent customer, would never sell a position for less than it’s full value to such people.

What he doesn’t get is that when he wants to sell a position at full value (think of a call spread for which both options are in the money, the strikes are 5-points apart, and the spread will be worth $500 at expiration), he expects some market maker to pay him that $500, and also pay commissions for making the trade. That would guarantee a loss for the market maker. Nevertheless, this customer still wants someone to pay $5 for the spread he wants to sell. When he cannot get that price, he blames the market makers for bidding less than the spread is worth.

I am not suggesting that the market maker is your friend. I am not suggesting that he/she is working to give you free money. However, many are decent, honest citizens trying to earn a living. If customers were better educated and stopped trowing away money, there would be less reason to seek someone to blame. Each trader can begin by observing two simple rules: never enter a market order when trading options and be certain that the specific options you are trading do not have special rules.

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10 Responses to Why does everyone hate the market makers?

  1. Dmitry 05/23/2011 at 1:09 PM #

    what i still dont understand is why indexes have such wide bid/ask spreads. i know you already answered that, Mark.
    Michael Benklifa, the author of this book, http://www.amazon.com/Profiting-Iron-Condor-Options-ebook/dp/B004K1F7HG/ref=sr_1_2?ie=UTF8&m=A2JEPUQV26074G&s=digital-text&qid=1306173694&sr=1-2
    claims that he runs a hedge fund trading ICs, and he mentioned that index option are still traded via open outcry, and this is where those bid/ask spreads come from. That`s why i asked you about this. If they rather trade electoricaly, those spreads are a… dont know how to call it.. shenanigan? In this case those MMs have what to hate them for. Buy @bid resell immediately @ask (to someone like me hehe) = easy money.. tons of it.

    • Mark D Wolfinger 05/23/2011 at 3:15 PM #

      Dmitry,
      I don’t know how much is still open outcry, but I believe it is very little.

      No Dmitry. They do not ‘immediate;y but at bid and sell at ask. There is not always that much two-way order flow. Sometimes they just sell, sell, and sell again. At other times, they buy, buy and buy again. It is not a case of they can tell what orders are coming next. Not all orders are good orders. People who have not been there do not understand that it is not as easy as it seems. In fact, there are almost zero independent traders left on the trading floors. Any who remain are working for big companies. The MM makes a trade and the computer guys ‘upstairs’ immediately hedge the trade. There is no buy/sell immediately. That’s just someones’ imagination.

      Most people are smart enough not to sell at the bid price and buy at the ask. But for people who do that, then the MMs are going to make a very good trade.

      In my pinion it is easy to blame the market maker when the real fault lies with the trader who did something stupid

      Regards

      • Casey 06/01/2011 at 2:14 PM #

        Market Makers do many illegal things. They float air shares around, they dilute prices back and forth amongst themselves. They are on par with repo men. That’s essentially what they do.

        • Mark D Wolfinger 06/01/2011 at 3:09 PM #

          Casey

          You have no idea what you are talking about. Sure there are bad eggs in every barrel, but do you hate all police because some are corrupt?

  2. Dmitry 05/23/2011 at 1:16 PM #

    Yeah i found that place in his book:
    “Whereas the rest of the trading world has gone electronic, the indexes are traded the old-fashioned way, by open outcry. blablabla. There is frequently a large discrepancy in the bid-ask on the computer screen and what is actually traded in the pit”.

    • Mark D Wolfinger 05/23/2011 at 3:16 PM #

      Yes. Computer screen is for the dummies who pay offers and sell bids or enter market orders.

      The real bid/ask is not shown

  3. Robert D. 05/23/2011 at 5:46 PM #

    Here’s how I look at it: If there existed no firms to facilitate equity markets (or options markets or futures markets), how could we hope to efficiently trade any of these financial instruments? What would it cost the average retail trader to provide for himself the services these companies provide?

    It’s funny what people choose to get worked up about.

    • Mark D Wolfinger 05/23/2011 at 10:36 PM #

      Robert D.

      It’s human nature at its ugliest. If you make any mistake, it must be the fault of someone else.

      Fall on the ice becasue you did not look where you were walking? Sue the property owner.

      Burn yourself with hot coffee because you were stupid enough to hold it in your between your legs while driving? Sue the restaurant (and she won)

      Lose money on an options trade? Surely not you. Not possible. The market makers must have cheated.

  4. Dmitry 05/24/2011 at 2:39 AM #

    So do you believe it`s ok not to know how much _exactly_ your position is worth today? I do mean the realistic price if course, based on the inside market. Come on, it`s 21 century after all, digital age!
    Im sure some day SEC will put their hands on option market makers. What i do NOT believe is that MM`s are some sinless honest citizens. They are there to make money from providing liquidity, like specialists. And specialists sure had (have?) an enourmous advantage compared to individuals. Why dont we see such gigantic bid ask spreads on nasdaq as we see on index options?

    “Yes. Computer screen is for the dummies who pay offers and sell bids or enter market orders. The real bid/ask is not shown.” This phrase in somehow shocking given how heavily everything is regulated in US, yet here it is.

    Please understand, i dont blindly hate MMs, in fact I know you, Mark, was one some time ago. So nothing personal 🙂

    • Mark D Wolfinger 05/24/2011 at 8:11 AM #

      Dmitry,

      I can know the approximate worth. I can estimate prices at which I can exit. But I don’t know how to learn the true bid without entering the order to close the position. And I will not do that.

      What I believe is wrong and unfair is that the rules allow such wide markets. At one time markets had to be tighter – by exchange rules.