Market Makers

If you currently trade, or are thinking about trading Exchange Traded Options (ETOs), then it is important to understand the way that the options pricing is determined and how you can identify genuine market pricing to maximise your profits (or minimise your losses)

When the price of the underlying equity moves up, then it is expected that the price of Call options will rise and the price of Put options will fall. If you study a particular stock and its option pricing you will notice that there are anomalies in the pricing. Some of this can be explained by volatility and the Delta of the option (sensitivity of the option price in relation to the change in the share price).

Market Makers:

One of the main reasons for the variation in the option price to the share price is that ETOs (options) are traded on a separate exchange that is subject to it's own supply and demand pricing, much of which is determined by the market makers.

Market makers play an important, but anonymous, role in the options market. Under ASX Market Rules they are required to provide quotes in various option series for certain periods of time. Market makers compete against one another while trading on their own account and at their own risk. They can be either individuals or firms and their raison d'etre is to make profit: they are YOUR competition.

There are around 20 market making firms in the ETO market. Companies such as Macquarie, Citigroup, JBWereGoldman Sachs are well recognised whilst others such as Optiver, Timber Hill and IMC keep a very low profile, although they are among the largest of the Market Makers.

The ASX rules: The ASX specify a maximum spread (the difference between the bid and offer prices) the designated market makers may quote when making a market and the minimum number of contracts for which the market maker must quote a price. The minimum volume requirement is ten contracts for Category 1 Classes and five contracts for Category 2 Classes (Categories basically reflect the price of the option).

Watch for the Sting:

How do you use this knowledge when trading ETOs? The temptation when trading an option is to pick a mid-point between the bid and ask prices as a 'fair' price. The market makers know this! In their eyes, you (the retail market) are a bit like sheep where you are able to be herded to a point where maximum profit can be extracted.

In the table below you can see the pricing for a BHP call at around 3.50pm on a day when BHP had been very bullish. The option had been trading in a range $1.52 - $1.55 with a fairly constant share price. You can see that the last trade was $1.535. You can also see that a market maker has placed a bid/ask spread of 10c ($1.525 - $1.625) for 10 contracts either side. Fair price is around $1.53. Therefore, anything that you pay above that is basically profit for the market maker. They are hoping that you will be desperate to get into BHP calls and are prepared to pay ~$1.60 - that is an instant 4.6% profit.

Options market maker spread