Market Makers

| February 28, 2012 | 0 Comments

Market Makers are individuals or representatives of firms who have a contractual relationship with the options exchange to ensure a fair and orderly two-sided market for the options to which they are assigned to make a market.

Market Makers must be members of the exchange, pay dues, and either own or lease a seat on the exchange to conduct business.  Market Makers are not permitted to represent public investors or traders; they must buy and sell options with their own capital for their own accounts.

The Market Maker adds depth and liquidity to the options marketplace by providing the best bids and the best offers to buy and sell options.  Through their large volume trading, market makers make it possible for there to be a large number of different option classes and a wide variety of options series within those classes.  If the selection of options available for trading depended entirely on the trading volume of public investors, there would be significantly fewer option classes and series.

The Market Maker also facilitates the execution of incoming orders by taking the other side of the transaction when there is no public investor to do so.  For example, if an investor places an order to buy a specific option and there is no public investor who wishes to sell that option, the Market Maker steps in and sells that call option to the investor placing the buy order.  The reverse is also true when there is no public investor to buy an option for which an order to sell that option has been received by the Market Maker.

In exchange for its obligations to make a fair and orderly market, a Market Maker is allowed to maintain a privileged position in the options marketplace.  The Market Maker is allowed to make a profit on each transaction equal to the difference between the bid and ask prices for the option being traded.

For example, assume that an option has a bid price of $1.00 and an ask price of $1.15 and that the Market Maker has received both an order to sell the option and an order to buy the option.  The Market Maker is permitted to buy the option for $1.00 and then turn around and sell that same option for $1.15.  The “spread” between the bid and ask prices ($0.15 in this example) represents the Market Maker’s profit from the transaction.

Given their unique rights and obligations in the options marketplace, the Market Maker uses a different strategy for trading options than the typical public investor.  The Market Maker is not concerned with the long-term direction of the underlying stock or index price.  He is focused on trading as many options as possible to maximize the profit it makes from the spread between the bid and ask price for each option.  By trading in large volume and hedging its positions, the Market Maker may capitalize on the small profit he earns from each transaction in which it participates.

In sum, market makers play a vital role in the structure of the options market by ensuring fair and orderly markets, providing the best bid and ask prices, and facilitating the execution of orders.  Investors benefit from the involvement of market makers through faster execution of trades and lower trading costs due to tighter bid/ask price spreads.  The end result is a more efficient market with better pricing and a broader selection of options to trade.

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Category: Options Trading Basics

About the Author ()

A former banking executive, Corey Williams is the Chief Options Strategist and co-editor of our well-known daily newsletter, Options Trading Research. Corey’s extensive experience with options goes all the way back to his days in corporate finance. It was this decade in banking where Corey discovered the most important skill an options trader can have– the ability to analyze a company or sector to determine its likely future direction. And now he’s brought this background, experience and love of options to Options Trading Research, the unique daily e-letter devoted exclusively to helping individual investors profit from the very lucrative options market.