Profitability of Options Market Making

[xflat2186]

Market making is not about trading direction. Its about trading the order flow for edge and managing the residual risks from the positions you are handed by the market. You don’t get your choice on what series you want to trade in a given issue, you have to make a 2 sided market in all the series in any underlying you’re in.


There are fewer and fewer firms as the markets tighten up and the expense of being a MM firm has increased. Payment for order flow, alone has forced many firms out of the business. Payment for order flow is when you the MM have to pay a kick back to the brokerages who bring retail customer order flow to you for you to take the other side of. As a mm you don’t and wont want to try and make a living purely off the order flow from other professionals. You wont want to trade with other MM’s much if at all too.

 

[traderbee]

Market making is not about trading direction. Its about trading the order flow for edge and managing the residual risks from the positions you are handed by the market.

can you explain this in plain english without using the jargon?

"trading the order flow for edge"
"residual risk"

Payment for order flow is when you the MM have to pay a kick back to the brokerages who bring retail customer order flow to you for you to take the other side of. As a mm you don’t and wont want to try and make a living purely off the order flow from other professionals. You wont want to trade with other MM’s much if at all too.

this is very interesting. why do the brokerages give you their retail order flow instead of executing it themselves. aren't the brokerages market makers too?

 

[xflat2186]

Brokerages are not mm's too. They may have divisions who do one or the other but the same division does not do both. There is a huge conflict of interest as you can imagine. Timber Hill is the MM arm of IAB. Obviously IAB would love to send every order they generate to their THI guys, they can’t really.


Market making in options or trading the order flow is about trading all the options orders which hit the pit whether it be open outcry or electronically. You as a MM are required to make 2 sided markets in every series of the underlying you’re singed in to. You’re essentially making your money on the bid offer spread of the options and then you’re left to manage the risk. That residual risk being delta or direction, vega or implied volatility, gamma which is the first derivative of delta, theta or time decay, rho which is interest rate risk. You don’t as a MM just walk around and buy some calls on a stock you think is going up roam from pit to pit putting on positions in whatever you feel like.

 

[magicz]

Quote from bidask:

can you please give an example of hedging?

how much capital do you need? how does the business work?

If you don't understand hedging different option position I suggest you do a little research on option, synthetics position, delta neutral position. I love to type it out for you but the info you need is easily available online, just google them.
xflat gave a very good description of how MM makes money.

 

[dmo]

Quote from traderbee:


Explain
"trading the order flow for edge"
"residual risk"

Imagine you're in a futures pit. At the moment, everybody is 3 bid at 4. That means everybody wants to buy at 3, and sell at 4. You want to buy at 3 and sell at 4 too. Why? Because at that moment, if you can buy at 3 (or "pay 3" in pit parlance), you have the edge. For at least a split second you cannot lose. You can always "scratch" or break even by selling at 3 to anyone in the pit. And there's a chance you can make a tick by selling at 4.

How are you going to get that edge? How are you going to buy at 3 or sell at 4 when the whole pit wants to do the same thing? By standing next to a broker who is filling retail orders and making nice to him. If a retail trader is bullish he's willing to give up a tick (buy at 4) because he has a longer time frame. But for the market maker, being able to sell at 4 - when whole pit is trying to sell at 4 - puts the odds on his side.

So when a retail trader puts an order in to buy at the market, the broker is going to fill that order by buying at 4. That means he has something valuable he's going to have to give to some lucky market maker (actually they're called "locals" in futures pits) - the ability to sell at contract at the offer, 4.

Xflat is talking about the electronic equivalent of that, which is essentially the same thing. I didn't know that in the stock market, market makers actually pay the brokerages for access to the order flow (which means the ability to buy the bid and sell the offer). Sounds like a system ripe for conflicts of interest. Makes me wonder if I'm not paying in other ways for those cheap IB commissions.

The risk for market makers is when the order flow is one-sided (all buys or all sells), and the market keeps moving in one direction. For option market makers, the risk is mostly vega, and also gamma. If all the orders coming in are buy orders, the market makers are going to just get shorter and shorter vega as implied volatility keeps relentlessly rising. If the underlying then makes a big move, the market makers are doubly screwed, because they're massively short gamma.

 

[bidask]

please describe the conflict of interest more. why is there a conflict of interest when the market maker pays for order flow? lets say i am making a market along with another market maker. these are our quotes.

me: 3-4
another market maker: 3-3.5

a customer at the broker i'm affiliated with sends a market order to buy. does that customer buy at 4 or 3.5?

now lets say this is the situation:

me: 3-4
another market maker: 3-4

what if the customer sends a limit order to sell at 4? does his order get filled before both of us?

does my customer only get priority over just me? or all the other market makers out there at the same price?

 

[xflat2186]

Quote from bidask:

please describe the conflict of interest more. why is there a conflict of interest when the market maker pays for order flow? lets say i am making a market along with another market maker. these are our quotes.

me: 3-4
another market maker: 3-3.5

a customer at the broker i'm affiliated with sends a market order to buy. does that customer buy at 4 or 3.5?

now lets say this is the situation:

me: 3-4
another market maker: 3-4

what if the customer sends a limit order to sell at 4? does his order get filled before both of us?

does my customer only get priority over just me? or all the other market makers out there at the same price?

That really depends on the product and the exchange. If you're pure retail you'll generally get priority over the market makers on the options side. There are issues on whether or not an MM is closing on the trade which effect parity and priority.

IN case one, the retail customer will always get the NBBO which in this case was 3.5.

In case two for options that customer would get filled ahead of a MM if 4 was the NBBO offer and they traded at 4 on the exchange where your offer was sent.

Again I am speaking in terms of options, thats my background. Payment for order flow has been around for many years in the pure stock business, and for about a decade in the options business. IMO it does create the potential for conflict of interest, but thats also mitigated by the NBBO rules.

 

[dmo]

Quote from xflat2186:

That really depends on the product and the exchange. If you're pure retail you'll generally get priority over the market makers on the options side. There are issues on whether or not an MM is closing on the trade which effect parity and priority.

IN case one, the retail customer will always get the NBBO which in this case was 3.5.

In case two for options that customer would get filled ahead of a MM if 4 was the NBBO offer and they traded at 4 on the exchange where your offer was sent.

Again I am speaking in terms of options, thats my background. Payment for order flow has been around for many years in the pure stock business, and for about a decade in the options business. IMO it does create the potential for conflict of interest, but thats also mitigated by the NBBO rules.

Thieves are a lot cleverer than the bureaucrats who make the rules. So any incentive to steal will always trump any rules put in place to thwart the theft.

I notice that IB charges me lower commissions if I use their "smart" order routing rather than specifying an exchange. Your post makes me wonder who is the beneficiary of that system's "smartness." I suspect it's not me.

Sometimes I'll see a stock is, say, 1.28 bid at 1.30. I'll put in a bid at 1.29. But the system still shows the bid is 1.28.

Doesn't that mean that if a retail customer puts in a market sell order, he'll sell to the MM at 1.28, rather than to me at 1.29?

 

[xflat2186]

I dont know the answers for pure stock trading, there are other rules for the NBBO in stock and they can print stuff outside the nbbo buy a governed amount.

As far at IAB goes, no matter where and how you send the order if you're a retail customer you get the NBBO. Now what their smart router does is decides where to send your order based first on the NBBO and then on where they have the best deal in terms of either taking the other side of the trade or in payment for your order. Either way in options you get the NBBO.

 

[Euler]

Quote from xflat2186:

As far at IAB goes, no matter where and how you send the order if you're a retail customer you get the NBBO. Now what their smart router does is decides where to send your order based first on the NBBO and then on where they have the best deal in terms of either taking the other side of the trade or in payment for your order. Either way in options you get the NBBO.

Note, however, that this scenario would give Timber Hill/IB an incentive to post a worse bid/offer than they would otherwise in certain circumstances, and that in turn may lead to a worse NBBO (from the perspective of the liquidity-taking customer -- and everyone else's customers, for that matter).

I'm not saying this actually occurs, but only that such an incentive may exist for any B/D that does both "smart" client order routing and market making, provided the "order interception" as describe by xflat2186 is legal, which I don't know.

One could minimize such potential conflicts by going with a so-called "agency brokerage" that does no trading on its own behalf, although the real-world impact of this potential conflict of interest to the typical liquidity taker may be very small.