What is option market making?
By Simon Gleadall, CEO of Volcube.
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‘Market making’ is a way of trading which involves being prepared to buy or sell a product (or range of products) and to manage the risk from the resulting trades. The market maker looks to buy and sell frequently so as to minimise the inventory (and therefore the risk) he holds and to capture as much of the ‘bid-ask’ spread as possible. The bid-ask spread is the difference between the price at which the market maker is prepared to sell the product and the price he is prepared to pay for the product.
Let’s consider an example. Suppose I am a market maker in barrels of crude oil. There is always a price I am prepared to pay for oil and price at which I will sell. Obviously the price I will pay will be less than the price at which I will sell. Now, hopefully lots of people will want to sell oil to me at my bid price and lots of other people will be happy to buy oil from me at my ask price. My profit will then be the difference between the bid and ask price multiplied by the amount of oil I trade. However, my risk is that instead of lots of buyers and sellers, there is a bias to either sell or buy. Imagine there are just lots of sellers of oil during the day. I will gradually reduce my bid price over the course of the day, but I am still likely to accumulate more oil than I really want to own. And the further the price falls, the bigger losses I will incur on my existing inventory. This simple example demonstrates the general idea of market making and the sources of the market maker’s risk and reward.
As for option market making, this is no different in principle to any other kind of market making. The options market maker looks to buy and sell options and capture the bid-ask spread. He will look to minimise the risk of his option position whilst he has one. One good way to do this is to trade options that have a lot in common, against one another. Suppose I show a two-way price to somebody (i.e. I show them a bid price and an ask price) and that they ‘hit my bid’ (i.e. sell me some options on my bid price). One way to reduce my risk if I cannot sell these exact options at a price higher than my bid price is to sell some similar options. The most similar options are likely to be options struck on the same underlying product, with the same time to expiration and with a similar strike. The more similar these other options are, the better they will act as a ‘hedge’ in order to lower the risk from the options I have already bought.
Options market makers look to make money by buying and selling options and hedging the associated risk using other similar options or other financial instruments. Their job is to manage the risk that remains from what can become complicated portfolios of options. You can experience being an options market maker by using Volcube. With Volcube, you can learn how to make a bid-ask spread in options and how to hedge and manage the risk of an options portfolio. And you can even become qualified as a Certified Volcube Options and Volatility Trader!
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