Options on Commodities Floor Traders

J

jfmiii

Hey all,
I've worked at the CBOT, CME, and NYMEX during college and currently trade STIR products for an institution but I've always wanted to learn how MMs trade in the options pit. I have a decent understanding of options but I'm curious how these guys make their money. Are they simply reading off the tablet or sheets and making a bid/offer and then delta hedging as the mkt moves? If they are always delta heding what happens if they get a hit for a 100 lot and the futures are only 10x10? I'd appreciate any insight. I'm specifically interested in what the guys trading corn, soybeans, bonds, eurodollars, and S&Ps are doing if anyone has worked in those option pits.
 
Quote from jfmiii:

Hey all,
I've worked at the CBOT, CME, and NYMEX during college and currently trade STIR products for an institution but I've always wanted to learn how MMs trade in the options pit. I have a decent understanding of options but I'm curious how these guys make their money. Are they simply reading off the tablet or sheets and making a bid/offer and then delta hedging as the mkt moves? If they are always delta heding what happens if they get a hit for a 100 lot and the futures are only 10x10? I'd appreciate any insight. I'm specifically interested in what the guys trading corn, soybeans, bonds, eurodollars, and S&Ps are doing if anyone has worked in those option pits.
More...

Technically, those on the floors you mention are not "market makers" as they have no obligation to make markets - just the ability to make markets if they choose. They're "locals." As a practical matter though, if they don't make two-sided markets the brokers won't routinely deal with them.

How do the option locals on those floors make money? There are as many answers as there are locals. Everyone has a different style or "game," as do the houses who put locals in the pit.

Generally though, it's a matter of buying wholesale and selling retail. The cheapness or expensiveness of an option is measured by its IV, not its dollar value, which is why locals consult theoretical value sheets (usually called "delta sheets"). You want to buy premium cheap and sell it expensive, trying to manage your position as neutral as possible.

Probably the toughest thing you face is when some big event happens (Chernobyl if you were in the grains then, the Continental Illinois Bank collapse in financials, mad cow disease if you were in live cattle) and premium gets bid up to the moon. You're the one selling it, so it's hard not to get way short gammas just when you least want to be short gammas. I was in T-bond options during the Continental collapse, and the biggest "market making" firm in the pit, CRT, damn near went bust.
 
Quote from jfmiii:
.....what happens if they get a hit for a 100 lot and the futures are only 10x10?
More...
1) Try not to bid or offer much larger size than what's showing in the futures and also what's available elsewhere at the different option strike prices. Don't overtrade relative to what everyone else is "leaning on".
2) A "good" floor broker will tend to avoid "jamming" a local with huge size that's beyond what the local is believed to be capable of handling. The broker doesn't want to gain a reputation for "picking people off".
3) It's possible that a broker will do a "huge" order with a trader and then immediately offset part of it or all of it to create a "scratch" trade with the same trader and then try to "feed" gravy/easy-money to the same trader later in the day as a favor for getting the huge order filled quickly. :D
4) Sometimes the trader can get "stuck" and everyone else in the pit will look at you helplessly. It happens. :eek:
 
Also, there are different rules and customs at different exchanges. On the CBOT floor for example, if you say "ten bid," without specifying a quantity, you have no obligation to take more than one lot. So a transaction might go like this:

Local: Ten bid
Broker: I sold you a hundred
Local: No, I'll take just one

But at the CME, if you don't specify a quantity, the broker can stick you with as many as he wants, no limit. Very dangerous for the local!

After 3 years on the CBOT floor, I went to the CME live cattle options pit. I was bidding on some option, and a broker hit me with a 500 lot! I said "I'll take 50." He said "You didn't put a number on it, I sold you 500!" What a scumbag - but he was stuck with an order he had to fill, so better to screw me than take the loss himself I guess.

At least, I never again forgot to put a number on my bids and offers!

There are other "cultural" differences. At the cbot, if you say "volatility came in," that meant it went down. At the CME, "volatility came in" means it went up. Now that they're both on the same floor, I wonder how those differences have resolved themselves.
 
i worked in the grain and treasury futures pits many summers while in HS and college, but unfortunately never had the foresight to get into one of the options pits. i understand the concept of bidding and offering around IV, i just dont understand what they do after that. if they can lean on another strike, i get that but if they arent doing that, what are they doing with their book between now and expiration?
 
Quote from jfmiii:

i worked in the grain and treasury futures pits many summers while in HS and college, but unfortunately never had the foresight to get into one of the options pits. i understand the concept of bidding and offering around IV, i just dont understand what they do after that. if they can lean on another strike, i get that but if they arent doing that, what are they doing with their book between now and expiration?
More...

Leaning on another strike is ideal, but not always possible. Most of the time IV doesn't move that quickly, so if you buy or sell premium, the probability is that an opportunity to offset your long or short premium will come along soon.

But during those times when IV IS moving rapidly, how you handle that depends on who you are. If you're a big firm, you just keep making markets. The details of how you manage your firm's position and how you adjust your markets during those times is proprietary to each firm. If you're an independent local without the staying power of a firm, you may take a directional position on premium, or you may decide to make very, very wide markets. Or you may just decide to stand aside until the dust settles.

But during normal times, if you find yourself uncomfortably short premium for example, you just become the best bid in the pit until you buy enough premium to feel comfortable again.
 
I was an option market maker in the crude oil & natural gas options pit on the NYMEX for many years. The "locals" - guys who work for themselves (as I did) or very small proprietary firms (as I did), use their trading sheets to tell them the fair value of each option at that very moment in time based on where the futures market is trading.

Almost all of the time, you will build a position of options and futures and try to stay delta, gamma, theta & vega neutral. This is done by constantly re-hedging via the futures market and/or trading other option strikes. The key was to buy below what your sheets were saying and/or sell above what your sheets were saying. Of course that didn't always happen, especially if the brokers were one sided and left you with a lopsided position skewed to either a huge long vega position or a huge short vega position. Over time, you would try to unwind your position at favorable prices which is how you would make some of your money.

In the NYMEX option pits, if you didn't specify a size on your bid or offer, it was usually assumed you were good for 50 or 100 lots, but if you only took 1 lot, the brokers would get a little pissed at you.

As far as how to size up your option bid/offers now with the futures market being electronic and not very deep, I would keep the size smaller than when the futures pit was still active. I left the floor before the electronic futures took over.

I wrote about some of the floor action and culture in my book, as well as the option strategies I like to use:

Hope my comments help some of you.
 
thanks for all the responses guys...

so assuming, for argument's sake, the local only has a position in one strike. he is delta, vega, theta neutral. at expiration, his profit should be, at least theoretically, the difference between where he bought or sold the option and its fair value at the time. is that right?
 
The profit or loss on that one option position will be affected by the difference between the original buy or sell price vs its fair value at expiration (as you mentioned), and the profit or loss on the futures hedges the trader did while the position was open (assuming the trader did futures hedging).
 
You must log in or register to reply here.
Back
Top