My Perspective as a Former Market Maker
As a former market maker on the CBOE, I have a unique perspective on how stock options are priced.
Survival as a market maker is dependent on making consistently efficient markets, meaning you need the ability to price options to the $.01.
That doesn’t mean you need to have a bid (to buy) and an offer (to sell) on every strikes that's $.01 wide, for example, $.10 bid @ $.11 offer — but you do need to figure out the value of every option (that's called your theoretical value).
Most traders look at option prices (the implied value) as the correct market. That may work for Retail Traders, but market makers need to be one step ahead of the market. Let me explain why.
Here’s the fallacy that I see shared across blogs, social media channels, and popular news outlets -they believe market makers are the party that controls price. Some even suggest that market makers have an influence on direction too. From a professional perspective, this thinking is incorrect. Market makers are small players in a market dominated by ‘real’ institutional dollars.
The Reality Behind how Market Makers Value Stock Options
A market maker is ultimately willing to make a market in any stock option, with the objective of taking out small profits. They do not speculate on direction; in fact, they usually have no interest in the direction of a stock. Market makers trade their portfolios delta neutral. By trading their accounts delta neutral, they take direction out of play and focus on the value of movement, which is referred to as volatility.
Most professional traders don’t care which way the underlying stock moves; rather, they are concerned with how much or how little a stock is moving.
Here’s an example: If a stock historically gyrates back and forth in a huge range (the difference between high and low price) but recently has been trading in a tighter trading range, a market maker may ‘skew’ their markets to the upside, which means they have more aggressive buy orders than sell orders.
The reason to skew your market this way would be an expectation that the underlying stock would move as it historically did when it was moving with higher volatility. When a trader buys options (calls or puts) they are buying volatility with the expectation that movement will increase (be less predictable), when a trader sells options (calls or puts) they are placing a bet on lower volatility or less movement.
To be clear, market makers have zero influence on the direction of an underlying stock. Most of these Professionals are looking to make good markets, with as much edge (an advantage) as possible and then quickly flip those trades for a quick profit. And now, with the onslaught of automated market makers, this proves truer than ever.
Now, you may be thinking if they don’t know direction than how do they value all these options to the penny?
The only indicator used (from my experience) is having a complete understanding of institutional trading activity (often referred to as Unusual Options Activity).
Not just understanding these trades, but quickly being able to interpret the intention of these orders.
Here’s another example – if a huge stock option order comes in to buy the 12 strike calls when the underlying stock is trading at $10 – many immediately consider this a bullish trade.
But, if that massive trade was done while simultaneously selling the underlying stock, that trade is now bearish. Market makers need a quick understanding of synthetic options positions like this:
Long call + Short stock = Long Put.
How All Market Markers Price options
In truth, I’ve never met a market maker who uses technical analysis or any indicator to value options. (except on webinars 🙂 )
Stock Options are unique to just using underlying stock volume because all options trades are 100% transparent. For a market maker (or any options trader) seeing the complete story in ‘time and sales’ data is priceless.
Let me walk you through one more example: XYZ stock trades at $10 and XYZ has options traded but the options do not have great liquidity. If 10,000 calls trade on the $12 strike for a price of $.70 – and at the time of the trade the market on that $12 strike was $.20 @ $.70…. market makers will raise their markets on ALL options in XYZ, and when I say ALL options that means all calls and all puts on every strike, in every month. That huge trade gives vital information to the trader. For me, my next market on the $12 strike upside calls might be $.60 @ $1.30.
To sum it up, market makers have ZERO influence on the direction of a stock. They can’t manipulate direction or play tricks with pricing. In today’s market they are small fish in a very big pond so let’s not blame these market participants when a trade goes against us… because they had nothing to do with it.
This is how option market makers price ALL options.
Former CBOE Options Market-Maker
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