Do Options Obey The Economic Rule of Supply and Demand?

B

bwilliams5534

Hi guys,

I have a very basic question about options and how supply and demand applies to them.

I have heard in the past that option prices follow the rules of supply and demand, just as all other functions of the stock market. Now, I find this statement to be a bit confusing since it seems that market markers have a never ending supply of options to give out. If this is the case, how can options really be based of supply and demand like a stock is?

Also, if options are based of supply and demand, what happens when someone makes an extremely large option order...(ie someone buying 5,000 calls on a stock where before the open interest was in the 100s) Wouldn't they simply bid the price up on themselves the order went through and the market maker would be able to see there is a large demand for the option and he could therefore charge whatever he wanted just as one could with a product in demand in the real world?

Also, when a large option order is given on a specific strike on a stock that overall has little open interest, do all the options within that stock follow the demand that has been shown in that one strike or should they not move at all since their has been no demand shown for them individually?

Thanks for any help you can provide on this newbie question I have.
 
Quote from bwilliams5534:

Hi guys,

I have a very basic question about options and how supply and demand applies to them.

I have heard in the past that option prices follow the rules of supply and demand, just as all other functions of the stock market. Now, I find this statement to be a bit confusing since it seems that market markers have a never ending supply of options to give out. If this is the case, how can options really be based of supply and demand like a stock is?

Also, if options are based of supply and demand, what happens when someone makes an extremely large option order...(ie someone buying 5,000 calls on a stock where before the open interest was in the 100s) Wouldn't they simply bid the price up on themselves the order went through and the market maker would be able to see there is a large demand for the option and he could therefore charge whatever he wanted just as one could with a product in demand in the real world?

Also, when a large option order is given on a specific strike on a stock that overall has little open interest, do all the options within that stock follow the demand that has been shown in that one strike or should they not move at all since their has been no demand shown for them individually?

Thanks for any help you can provide on this newbie question I have.
More...

An option is a contract. If I have no position and you have no position, and I sell you a call, then poof - an option contract has just been created out of thin air.

If I sell you 100 contracts (options - calls for example) at $1, I'm assuming risk. If you still want to buy more calls, I may no longer be willing to sell them at $1.00. If you want more, let's say, you're now going to have to pay me $1.20. If you buy 100 at $1.20 and still want more, I may say "they're now for sale at $1.40."

That's how options obey the rule of supply and demand.
 
Your assumption “that market markers have a never ending supply of options to give out” is completely incorrect. Market makers are no different than any traders as far as their risk goes. The more options they sell, then the more risk they take on. When the crowd has sold all they want to sell then the price will rise, which is implied volatility going up. In the old days we could raise one strike that the public was buying and leave the rest of the strikes the same, but you can’t get away with that anymore.
 
Quote from bwilliams5534:
.....market markers have a never ending supply of options to give out.....
.....what happens when someone makes an extremely large option order...
.....the market maker would be able to....charge whatever he wanted......
.....when a large option order is given on a specific strike on a stock that overall has little open interest, do all the options within that stock follow the demand that has been shown in that one strike.....
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1) They don't have "infinite capitalization", just "large capitalization" and a potentially better risk profile.
2) A "large order" doesn't always move the market far away.
3) That can happen if there are not a lot of other resting orders and the customer is acting ignorantly.
4) "Relative value" needs to be maintained between other option strike prices and option contract months. Traders will generally look to spread-off the "big order" versus other options and the underlying instrument.
 
Quote from bwilliams5534:

since it seems that market markers have a never ending supply of options to give out...
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We all agree that this is not true, but what I'd appreciate your telling us is:

Why did you believe that was true? Did you read it? Did someone tell that to you?

Mark
 
Quote from opt789:

Market makers are no different than any traders as far as their risk goes. The more options they sell, then the more risk they take on.
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What's the market maker's risk if he arbs a conversion or reversal to create the options that he's selling to you?
 
Quote from spindr0:

What's the market maker's risk if he arbs a conversion or reversal to create the options that he's selling to you?
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The risks are the same as anyone else with a reversal/conversion which are interest rate risk, dividend risk, and pin risk. Also there are few times when a market maker is handed an arbitrage, he (or she, although there are not many they are quite tough) is usually doing one side and then the other at a different time.
 
Hey guys thanks for all the replies so far,

On Fast Money today they kind of provided an example of what I was talking about when they discussed a trade some large institutional trader made on the XLI’s options. Since it related so well to this discussion, I figured we could go through it here and I could show you guys why I am confused about whether options pricing really have anything to do with supply and demand.

The original trade was made on 3/5/09 on the XLI April 18 calls. About 259,000 contracts were traded. Prior to this, the open interest on the April 18 calls was only at 100 contracts. On the day of the trade, the calls traded between .20 and .35 cents(I do not believe a call ever traded at .35 cents but the ask was held at that price from 9:30 AM to about 2:29 PM), the large call order was purchased at 2:31 PM for .30 cents. When looking at the bid and ask on that call option from the day before(low was .25 cents and high was .35 cents, stock was at 16.30 as opposed to 15.67 on day of trade) and the day after( low and high were the same as the day of the large trade at .20 cents and .35 cents, and the stock was basically flat as it was down 1 percent from day of trade) this trade did not seem to effect the pricing at all. During this time the IV of options basically stayed flat as well going from 50% the day before to 56%(IV rise here was probably due to a 3.67% drop in stock price, and did not have to due with the options) the day of to 55% the day after. Today at 12:11, this institutional trader was able to sell all the call options at once for its high of the day of $1.50(underlying ETF was making its high at this time as well). He then immediately rolled this position up into XLI April 20 call where he then bought at the days high(and underlying ETFs high as well).

Now this trade appears to go against a lot of what everyone had said in this thread. It appears that this trader was able to place huge orders without having the price go up or down when he bought or sold(each of the three times he was able to buy and sell 259,000 contracts at one price and in one minute, if I am understanding the chart correctly). And it seems like even though he was buying $7,770,000 and later selling $38,850,000 worth of options, he was still able to place the trade at the market price and did not have continue bidding the options up higher as he bought all these options…Now is this because the bid and ask spread works like an advertised price for market makers and they have to meet any trade no matter how large within the bid and ask spread as long as it takes place at once(although this doesn‘t seem correct because this order did not cause a price spark immediately after in the option chart I am looking at), or is it simply because a market maker knew that they could hedge themselves in this trade so they had no problem taking it on?

Also to dagnyt, I understand that market makers do not truly have a limitless supply of options to give out, but it seems that as long as they are able to hedge themselves, they can take on as large of an order as they want(or are they forced to?). In this trade, the market maker(s?) was able to take on about $7,770,000 in the sale of call options(and subsequently lose $31,080,000) because I am guessing he somehow hedged himself(most likely through underlying stock since no other options exploded with open interest, and the underlying stock had a large volume increase right after the original call option trade occurred), correct? So, am I correct to assume that as long as market makers can hedge themselves they basically have an unlimited supply of options to hand out, or is this still wrong?

Also, did the underlying being an ETF effect this trade at all compared to a trade that would take place on a normal stock?

So to conclude this long winded post, I guess what I am trying to ask is are options really based of supply and demand or are they only based on what their Greeks and underlying do. In this example it seemed that the supply and demand of options had no effect on the price of them, but the price of the underlying ETF had a clear effect as did the greeks. And just as the options pricing was not effected by supply and demand, it did not seem that any of the options greeks(ie vega) were effected by the options large demand increase…so I am just wondering were is the effect of supply and demand in this trade?
 
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