Exploit Market Makers For Personal Gain

Jan 12, 2022 EducationalInvesting Strategies

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Every time you buy or sell an option, someone acts as your counterparty.

But just who is that mystery person on the other side of the transaction?

Chances are, it’s a market maker.

You might have heard about these players in conjunction with Robinhood (HOOD) and payment for order flow.

Despite the negative rap they get, market makers serve a critical trading function.

Here’s the cool part: If you understand how they work, you can uncover opportunities.

That’s why I want to walk you through the ins and outs of the market makers’ business and how to use this information to create trade ideas.

What Do Market Makers Do?

I like to think of market makers as warehouses that store inventory. Their job is to fulfill orders placed by buyers and sellers.

In the graphic below, you’ll notice how the arrows between the buyer and market maker and seller and market maker are different colors.

This is intentional.

You see, the market maker doesn’t necessarily line up the buyer with the seller. While they often can, they don’t have to or may not be able to.

Instead, they keep a warehouse of stocks where they add and subtract inventory to meet orders from traders like you and me.

Source: TradeSmith

All day long, the market maker facilitates orders with buyers and sellers while maintaining a certain level of stock in their “inventory warehouse.”

To make money, these market makers will buy at a price slightly below the market from a seller and sell at a price slightly above the market to a buyer. This difference is known as the spread.

Oftentimes, the spread can be fractions of a penny. However, across millions if not billions of transactions, this becomes quite lucrative.

Some of the biggest players in the industry include Ken Griffin’s Citadel Securities and Goldman Sachs (GS).

What most people don’t realize is how much of the total market these firms make up.

In December 2020, the New York Stock Exchange made up 19.9% of total trading volume, followed by the Nasdaq Stock Market at 16.9%, and the Chicago Board Options Exchange at 14.4%.

Citadel Securities came in at a whopping 13.4%.

Source: Quartz

Why Do We Need Them?

Market makers aren’t well-loved by the media. However, they serve a critical role.

Without market makers, we would see fewer trades, wider price swings, and larger spreads.

Market makers add liquidity to trading, allowing us to buy and sell stocks, options, and futures when we want. They bridge the gap between us and the next counterparty.

In order for these firms to make money, they need volume.

So, many of them reach agreements with brokers to pay for order flow.

Essentially, a market maker pays a broker for the right to get first crack at filling an order before passing it along to the open exchange.

Many politicians have a problem with this because they see it as a conflict of interest.

However, the rules state that the market maker must fill the order at the best available price. So in reality, retail traders don’t feel the impact since they aren’t executing hundreds of thousands of orders a day.

Market makers also get a bad rap for high-frequency trading (HFT). High-frequency traders use extremely fast computing power and low latency speeds to profit from discrepancies between orders that hit the market. However, only some market makers are high-frequency traders, not all of them.

HFTs are controversial because they have been blamed for exacerbating market moves, such as the flash crash of 2010. However, proponents say they add liquidity to the market.

I’m not here to judge them one way or another.

What I can do is use this information to exploit flaws in their business model.

Market Makers and Options

As you probably know, options are derivative contracts that control the right, but not the obligation, to buy or sell an underlying stock at a given price.

When retail traders buy a call or put option, chances are the market maker is on the other end of that trade.

Once a market maker sells us the option, they immediately go in and buy or sell the underlying stock, or an equivalent, to offset the risk. This way, they hold no directional bias and profit purely on the spread between the bid and ask.

Here’s the interesting part.

Market makers don’t need to buy and sell 100 shares of stock for every option contract they sell. Instead, they only need to offset the “delta” of the option contract.

So if you buy a put option with a -0.10 delta, the market maker only needs to short 10 shares of the stock to offset the risk.

Delta is the change in the price of an option for a +$1 move in the underlying stock.

You can also think of delta as the equivalent number of shares you control. Calls have positive deltas, while puts have negative deltas.

Deltas are measured on a scale of -1 to 0 for put options and 0 to +1 for calls. -1 is about as far in the money as you can go for a put option, while +1 is the furthest in the money you can go for a call option.

As you travel upward (lower) on the strike prices, you go further in the money for calls and out of the money for puts. This causes the deltas for the call options to approach 1 while put options deltas approach 0.

Conversely, as you travel downward (higher) on the strike prices, you go further out of the money for calls and further in the money for puts. This causes the deltas for call options to approach 0 and put options to approach -1.

Source: ThinkOrSwim and TradeSmith illustration

Now, here’s the important thing to remember. As the price of a stock changes, so does the delta. That means that big changes in the stock’s price require the market makers to update their hedges to stay neutral.

Exploiting Their Business

We have all seen stocks gap up and down in the premarket based on earnings and other events.

Most of the time, market makers do quite nicely, since many of the unexpired put and call options we sell are too far out of the money and expire worthless.

However, every so often, a stock moves far more than market makers expected. And if they sold too many options to retail traders like you and me, they’re in a lot of trouble.

In order to cover themselves, market makers will need to buy or sell the stock to remove their directional bias.

Here’s where things get interesting.

When a stock gaps up too much with too many open options, the market maker is forced to BUY the stock because they sold calls.

When a stock gaps down too much with too many open options, the market maker is forced to SELL the stock because they sold puts.

If that sounds odd to you, just remember that whatever benefits you hurts them. So they need to do the opposite of their position to balance themselves out.

This creates situations where a stock that is already hugely up or down on the day can keep on running.

Now, there is no exact formula for what constitutes a humongous move or too many options.

However, there’s a neat little trick you can use.

You can look at the at-the-money straddle price (the price of buying a call and put at the money based on the prior closing price) in the premarket to get an idea of the “expected move” for the stock.

I know this is a bit abstract, so let me give you an example.

Let’s say that Apple (AAPL) closed Monday at $120. Tuesday morning, it’s trading at $130.

Before the market opened, I looked at the $120 strike price for the cost of a straddle (the cost of buying a put and a call) and found out the cost was $5.

That means the market (and thus the market makers) expected the stock would land between $115 and $125 ($120 plus or minus $5) by expiration.

However, with the stock trading at +$10, that means it’s trading at two times the expected move.

If a stock is more than two times the expected move, that makes it more likely the market makers have not offset enough risk for that move.

So if you see a stock that is about to gap up or down two to three times the expected move, and there is a lot of open interest out there, chances are the market makers will be forced to buy or sell the stock to hedge their risk, pushing the stock even higher or lower than where it opens.

Here’s how you might practically apply this:

  1. Look for a stock gapping up or down a lot in premarket trading.
  2. Find the straddle price.
  3. Compare the straddle price to the total difference between the premarket price of the stock and its closing price from the day before.
  4. Check open option interest that is below the current premarket price
  5. Once the stock opens, you can trade it with an expectation it will move higher if it gaps up, or it will move lower as it gaps down.
This is just one area of the market that retail traders can exploit for their own gain.

What are some others you’ve found? I’d love to hear from you.

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