Hi. I've been trading options in US and HK markets for about 5 years so far. One question has been bothering me for a couple of years already and I can't find the exact answer:
So the thing is that 95% of trades that you execute in the options market are against market makers – that's your counter party. And they don't work there with a loss obviously. Now, if you read articles about market makers on the internet you will most likely find out that they, similarly to a broker, try to earn a fee from executed trades without exposure to market risk by hedging their positions. So in options market it means that all open interest against them they are supposed to hedge with stocks, futures or other option contracts in a such a way that they don't care where the underlying goes – and adjust these positions regularly to maintain this delta-neutrality. Their income is mainly bid/ask spread in options contract and rebates in this logic.
But that's on paper and a classical notion of market making. My question is: Is it required by law or SEC/OPRA regulations to act like that and stay market neutral for them? Or are they allowed to actively participate in the market at the same time (if they want) and not hedge their positions fully?
I am asking that because if it is not a requirement for them by law then I can come up with lots of ideas for them on how to profit more than spreads and rebates. These are huge Wall Street Companies with lots of capital and media resources. For instance, one idea: spend 100-1000M$ in the after-market, pre-market session to control stock price in such a way that options open interest worth 1-2B$ in premiums expires after company's earnings report. Report is good – but who cares… we can ignore hedging 1-2B$ worth of option contracts to earn the whole premium if we spend another 1B$ on maintaining stock prices in a range – then will close these positions later with 200-300M$ loss perhaps, or will resell them to some affiliated mutual fund / etf provider quietly off-the-market. Another less cruel idea: We have an affiliated fund / etf manager – they want to increase position in the underlying where we are market making – don't fully hedge open interest and through derivatives pass your exposure to the fund / etf – your market non-neutrality is passed to the performance of fund/etf – let its investors bear this risk – and earn full premiums again.
So all this (and much more) can be happening I suppose unless there is a strict requirement to stay market neutral for them and regular audit. Market Making is regulated overall but I couldn't find in the SEC/OPRA documents anything related to this matter (perhaps I was searching for wrong key words there). Does anyone here happen to know the answer?
Are market makers required to hedge their open interest in a delta-neutral way by law?
byu/Ch4Rm0nY inoptions
Posted by Ch4Rm0nY
7 Comments
How do you define being neutral? Based off model A or model B? Neutral at the top of the hour or every minute.
So…no, nothing requires them to hedge
1. They are not required to stay neutral. They do make money from positionning and often do not hedge at all. For example Citadel is a market maker, but was cought with their pants down during the GME short squeeze a couple years ago.
2. Yes they do manipulate certain stocks to their favor. Look up the options max pain theory .
If you work for a bank, some Dodd-Frank provisions around prop trading might apply, but broadly no. Every market making desk will have a delta limit imposed by risk management though.
Your role is to make money from making markets and executing client flow, not directional bets and there’s lots of safe guards against unfettered speculation.
There are 2 types of market makers we could be talking about there. We have unaffiliated MMs and DPMs/LMMs. DPM stands for Designated Primary market maker and LMM is Lead market maker. These market makers have arrangements with the exchanges of which the stock and thus options are listed. They get paid to be there and they have to follow more rules on width of quoting and time of quoting.
The LMMs are there to get the rebate and fee back from the exchanges and they also do this for fee minimization as there are rules that they get small contract flow from retail when they send it to exchange. Most of these LMMs are wholesalers (they buy flow and match it then send to exchange).
The other type of market makers are those that do no not have an affiliation with the underlying and are just in the market for that stock. A firm can be a LMM on one ticker and a regular mm on another without an arrangement with the exchange.
This sets up the point I’m trying to make which is if the firm is a LMM on a ticker they will not try to fuck with the price at all and move it because it does not make sense for them to do it. If they get caught by the exchanges doing this they lose a huge amount of potential profit they are currently making with their elevated status. Everybody would love to be a LMM on a big ticker and there are fights for those positions.
When a firm is not in that LMM spot they could theoretically move the price around a bit but they also have to be very careful as to not market manipulate and also not get picked off. When quotes are moving these MMs are constantly updating their prices to make sure they don’t enter any edge negative trades and when you start moving a price against or without the market you are opening up a massive opportunity for other MMs to pick you off. Firms that get caught in this position get hit for hundreds of thousands of dollars in losses just because they were not fast enough to adjust their quotes.
With all that being said It becomes extremely difficult to convince the rest of the market of a different price and the risk is opens up is so high most if not all firms will not even attempt something so brazen as what you describe.
Edit adding more:
With your example of moving a post earnings report company with the premiums to have them all expire worthless. It will take way more than a couple billion to maintain a false price. Market forces move so hard and if market forces are a wave and they are a dam, a dam never fails gracefully. Traders at these firms could try something like this but risk management algos would block it so hard as even taking a 2-3 hundred million dollar loss there would not be stomached. MMs make their money in slight mid matches in price and spreads. There is little motivation to go far beyond that on the MM side. Hedge funds could do this a lot easier since they are expected to be none market neutral.
Many MM firms are required to be Delta neutral at the end of the day like citadel and others are hedged as the trades are made. I just don’t see anything of what you described happening in a MM shop.
Source: I work for a MM
The stock market is the new frontier of the Old Wild West. The Markets are ‘mostly’ the land of the unwilling. Nothing is illegal here. You play to win but mostly you lose unless you know the rules of the ring you get into.
No, they are not required by law to keep their positions delta hedged. Also, no they don’t receive a fee like a broker, but yes, they might have an incentive/rebate scheme more favourable than yours, depending on the exchange and the type of market maker status they have. Lastly, you don’t have strategies they could use to increase their profits. Trust me. These shops are light years beyond whatever you can ever conjure up on your own.
Is this a joke?