How Sports Bettors (And Others) Forced Market Makers To Surf The Retail Wave

I have become much more popular over the past few weeks, at least among financial reporters. While I would like to attribute this to my innate wit and charm, it is really because I have the type of trading and market-making experience that can help them make sense of the consequences of the recent popularity of options, particularly the popularity of call options among retail investors.

Seemingly at once, retail investors became enamored with call options on highflying technology stocks. It is good that a wider range of clientele is learning about and utilizing listed equity options, but the pace of that adoption and the conditions under which it occurred caused disruption to options prices and markets as a whole. Any markets that are exposed to disruptions are primed for volatility, and that volatility manifested itself over the prior two weeks. 

Just before the markets lurched lower, I published this piece about how the skewed prices of certain options classes were displaying a potentially unsustainable preponderance of greed over fear. It seems obvious that increased demand for something, in this case, call options, would push up prices for that item. What is less clear, and what I hope to explain here, are the mechanics that underlie those price increases.

Let’s say a trader starts out with no positions and believes that the fair value of an option is $2. He will post a two-sided market with $2 as the midpoint, say 1.90-2.10. If someone lifts his offer at $2.10, his next posting would likely be $1.95-$2.15. If someone hits his $1.95 bid, the market would probably revert to $1.90-$2.10.This is the ideal situation for a market maker, selling on the offer then buying back on the bid and locking in a profit with no residual exposure. But let’s say that the second customer is a buyer. In that case, he would probably go to a $2-$2.20 market. If the buying is relatively tame, and the market maker is finding it easy to hedge his risks, the price rises will be moderate. If the market maker sees an unrelenting wave of buying, however, he has no choice but to raise his offer aggressively. He will also likely widen his spread, say to $2-$2.50. This is because he is unlikely to want to lock in a loss on his sales by raising his bid above those sale prices, though bid prices will rise when a disciplined market maker will ultimately acknowledges when it is safer to lock in a loss than to ride a bad position.

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Disclosure: The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the ...

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