I think I get it, if the market is covering the Stock, it would buy up the Options to the Point where the prices reflect the expected move. The Volatility Frown comes into existence. On the way to a balance between buyers and sellers/when there is an overhang of buyers, do market makers have to fill the price they quote at any given point in time? Or can they decide/delay the point at which they give buyers a fill/can they wait untill the have roughly the same ammount of buyers and sellers (not considering spreads in this scenario)?
How do Market Makers determine the Option Price in binary Situations?
- Thread starter Atikon
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I think I get it, if the market is covering the Stock, it would buy up the Options to the Point where the prices reflect the expected move. The Volatility Frown comes into existence. On the way to a balance between buyers and sellers/when there is an overhang of buyers, do market makers have to fill the price they quote at any given point in time? Or can they decide/delay the point at which they give buyers a fill/can they wait untill the have roughly the same ammount of buyers and sellers (not considering spreads in this scenario)?
Do MM look at buyers bids first before posting their ask/bids or is this a gradual process where the MM post a Bid ./Ask and then looks at the Buyer/Seller Discrepancy and adjusts?
I'm trying to understand whether the MM is reliying on the Efficient Market Hypothesis or whether MM are ahead of the curve
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A MM is most concerned with inventory. As more traders come in to buy options, the market maker will keep adjusting his quotes higher. Think of it like Micro Econ 101 - The second slice is never as satisfying as the first slice.
If there is not much liquidity, then the bid/ask will be much wider as the market maker will mostly likely have to hold inventory through the binary event.
The MM always risks the chance of being picked off - you might have some insight on the earnings event and you decide to lift his offer. For that reason you will usually see bid/ask spreads widen during these events.
The question you should be asking is how do traders price these events?
Most of the time when there is a break in the tree you will see a smile on the surface - both delta 25 put and 25 call trading above ATM.
Let's take a look at what happened to ACB recently. 1 week Ivol went to 500%. Do you think market makers forecast of realized vol was anywhere near that number? Almost certainly not.
Who do you think was selling vol on ACB? IMO it was just @Magic and I - large firms can't go near it. The same things happens around earnings events.
I think I see what you are trying to do. I was asking the same questions once. Instead of thinking how the MM are pricing these options, think about who is buying here and who are the sellers. Put yourself in positions where the other side of the trade is a known group like retail, try and figure out where the imbalance in supply demand is coming from. If it all lines up, take the trade.
I hope that helps.
p.s. Selling high Ivol when you have no clue why it's high is the number 1 mistake I made when I first started trading earnings. I say this because I see on this forum you are very much into earnings trading
If there is not much liquidity, then the bid/ask will be much wider as the market maker will mostly likely have to hold inventory through the binary event.
The MM always risks the chance of being picked off - you might have some insight on the earnings event and you decide to lift his offer. For that reason you will usually see bid/ask spreads widen during these events.
The question you should be asking is how do traders price these events?
Most of the time when there is a break in the tree you will see a smile on the surface - both delta 25 put and 25 call trading above ATM.
Let's take a look at what happened to ACB recently. 1 week Ivol went to 500%. Do you think market makers forecast of realized vol was anywhere near that number? Almost certainly not.
Who do you think was selling vol on ACB? IMO it was just @Magic and I - large firms can't go near it. The same things happens around earnings events.
I think I see what you are trying to do. I was asking the same questions once. Instead of thinking how the MM are pricing these options, think about who is buying here and who are the sellers. Put yourself in positions where the other side of the trade is a known group like retail, try and figure out where the imbalance in supply demand is coming from. If it all lines up, take the trade.
I hope that helps.
p.s. Selling high Ivol when you have no clue why it's high is the number 1 mistake I made when I first started trading earnings. I say this because I see on this forum you are very much into earnings trading
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Here I would say: it depends.
For example, look at microcap stocks like pink sheets or the canadian miners. A market maker there has so called mandates. Since there isn't really a correlated asset for these stocks where he can hedge his inventory, the MM receives a fixed sum between 50k and 100k to post bids and offers in that stock.
He knows the management, he get's the news first, so in this case he's ahead of the curve...but when he's stuck short, he's stuck short and he'll lose a lot of money.
In options, you more or less rely on the mean reverting features of volatility and the convexity of derivatives. Ideally you want to be +theta, vega neutral and +vomma, so you make money when the market stays where it is and when it explodes.
Inventory construction and position dissection is really key here, since you will be trading 100s of different strikes and terms, and just because your greeks look good at the moment you still wanna make sure you don't have a lone 50 lot of short wings somewhere that wakes up and hits you in the balls when you don't expect it.
In futures, most market makers trade basis, meaning they do some sort of cash vs. futures trade. That's basically how ALL commercial commodity traders operate. Scrape together inventory below futures price and hedge it with futures to build up inventory and either sell cash above futures price+buy back futures or deliver against the futures.
The biggest carry trade that is running at the moment is in COMEX gold.
Gold is in yuuge contango right now, so everyone is buying physical, ships it to COMEX warehouses and delivers against futures.
https://www.cmegroup.com/delivery_reports/MetalsIssuesAndStopsMTDReport.pdf
Add up May and June delivery notices: that's 7.3 million oz of gold to be delivered
I want to add one last thing here, which should spark up a lightbulb above some guys heads:
The market price is a function of all participants inventory NOT of no-arbitrage criteria or some mathematical function. The bigger a market participant, the more influence his inventory has on the price of the asset.
This means that prices can be out of line for a very long time for everyone to see.
But as long as the flow does not reverse it will stay that way.
In other words, let's say a stock costs 5$ and the 3m ATM put is 6$ - which is a huge arb. When there is nobody left that has the cash or the market access to actually make the arb and all other participants are already loaded up to the brim...then the mispricing will not go away.
This leads to the biggest edge a retailers can have: He can stay out of the market until a mispricing occurs and as soon as it does, take advantage of it.
The market price is a function of all participants inventory NOT of no-arbitrage criteria or some mathematical function. The bigger a market participant, the more influence his inventory has on the price of the asset.
This means that prices can be out of line for a very long time for everyone to see.
But as long as the flow does not reverse it will stay that way.
In other words, let's say a stock costs 5$ and the 3m ATM put is 6$ - which is a huge arb. When there is nobody left that has the cash or the market access to actually make the arb and all other participants are already loaded up to the brim...then the mispricing will not go away.
This leads to the biggest edge a retailers can have: He can stay out of the market until a mispricing occurs and as soon as it does, take advantage of it.
Let's not be silly here implying that the arb you described ever exists, not at a dollar and not at a nickle. There's never a time that all the professionals have used their capital and the patient and wise retail investor swoops in and takes an arb significantly exceeding transaction fees, full stop. You may on rare occasion take a few pennies on an arb at the close while really exposing yourself to pin risk you weren't aware of or something similar, but what you're describing is pure fairy tale stuff. Would love to see trade confirms if you think I'm wrong in that.
I guess I didn't understand your point then. I thought you were saying that exploitable arbs occur in real life when professionals are so fully invested they don't have another dollar to take advantage of them. That doesn't happen, but if that wasn't your point then I guess it doesn't matter.
There aren't any professionals investing in penny stocks, so I'm even more confused by the reference to pump and dumps?
Hull, Chapter 20. Since I don't understand the math, my comment was just intuitive.