How do market makers work?

twaddle · 01-25-2008, 01:51 PM

So I made a small fortune selling June-30 EGLE calls a while back, and I figure now looks like an OK time to cover.

Basically zero volume today, but the market makers are sitting there with bids at 0.35 and asks at 0.60.

I put in a bid at 0.40, and all of the market makers immediately adjust their bid to match mine, *and* it looks like they jump ahead of me in the queue.

How and why do they do that?

haha · 01-25-2008, 02:02 PM

Quote:

Originally Posted by twaddle

Basically zero volume today, but the market makers are sitting there with bids at 0.35 and asks at 0.60.

I put in a bid at 0.40, and all of the market makers immediately adjust their bid to match mine, *and* it looks like they jump ahead of me in the queue.

How and why do they do that?

I am not sure I understand your question about how. But why? Because they are pr*cks!

Ha

twaddle · 01-25-2008, 02:06 PM

Two part question on the how:

1) They obviously have some automated tool to adjust bids whenever a new bid comes in. Where do I get such a tool, and are they adjusting because they know their bid is below fair value?

2) How do they jump in front of me in the queue (or does it just look that way)? I would have assumed that the first high bid would be at the front of the line for any incoming sales.

FIRE'd@51 · 01-25-2008, 02:18 PM

My broker's option quote shows the bid/offer but not the bid/offer sizes. I think you may be seeing your own bid.

haha · 01-25-2008, 02:18 PM

Quote:

Originally Posted by twaddle

Two part question on the how:

2) How do they jump in front of me in the queue (or does it just look that way)? I would have assumed that the first high bid would be at the front of the line for any incoming sales.

I see. If they are doing that, it doesn't seem like it should be kosher. But regarding this, see my post above on the "why".

As to question question #1- I would expect that they know that their bid is below fair value. Isn't that how they make money?

Ha

twaddle · 01-25-2008, 02:21 PM

Quote:

Originally Posted by FIRE'd@51

My broker's option quote shows the bid/offer but not the bid/offer sizes. I think you may be seeing your own bid.

I'm looking at level-II, which gives me the queues for different exchanges and shows the number of bids in each, so I can pretty much see where mine ranks.

FIRE'd@51 · 01-25-2008, 02:39 PM

Quote:

Originally Posted by twaddle

I'm looking at level-II, which gives me the queues for different exchanges and shows the number of bids in each, so I can pretty much see where mine ranks.

Just curious. If you cancel your bid, do you see the others go back to 0.35?

twaddle · 01-25-2008, 02:46 PM

Hmm, good question, but I don't want to cancel since I got a partial fill. Next time, I'll experiment a bit. Hmm, maybe I can manipulate them by submitting a bogus ask and then following up with a real bid when they all shift to my ask.

clifp · 01-25-2008, 02:49 PM

Looking at the L2 quotes I see all the exchanges show a bid of $.40 and the asks varying between .55 and .70.

To answer your original question. I believe (but do not KNOW) that there are computerized programs that do automatic adjustments. So if the theoritical price of the option $.50 but the best bid $.35 they'll match the best bids as long as it is below .$50. As far as how the priorities are set who's .40 bid gets accepted. Last I asked the Schwab guys to explain this the basic answer I got was it is really complicated.

I think that means the little guy gets screwed but perhaps only a little

FinanceDude · 01-25-2008, 02:50 PM

Quote:

Originally Posted by twaddle

Hmm, good question, but I don't want to cancel since I got a partial fill. Next time, I'll experiment a bit. Hmm, maybe I can manipulate them by submitting a bogus ask and then following up with a real bid when they all shift to my ask.

Good luck on that.........

Put another way, the market makers have stickers on their BMW's that say:

"My Software Can Beat Up Your Software".........

FIRE'd@51 · 01-25-2008, 02:56 PM

Quote:

Originally Posted by twaddle

Hmm, good question, but I don't want to cancel since I got a partial fill. Next time, I'll experiment a bit. Hmm, maybe I can manipulate them by submitting a bogus ask and then following up with a real bid when they all shift to my ask.

I would be careful playing those games in the event you get filled on your bogus ask.

I just did a rough calculation with my Black-Scholes calculator, and I estimate the hedge ratio for that call to be about 0.2, so a 0.25 move in the stock will move the fair value of the option 0.05. I'm sure the market makers have their bids moving around electronically with the underlying stock. Could this be what is happening?

twaddle · 01-25-2008, 02:59 PM

Yes, they do that as well, but this isn't the first time I've seen them move as soon as I place a bid. And they don't all move, so they seem to have different thresholds.

ERD50 · 01-25-2008, 05:16 PM

Just a guess, but on low volume options, maybe their software is not updating as often? But then maybe the calculation gets re-prioritized whenever there is a new bid or ask placed?

If I was writing the algorithms, I'd probably do something like that. When you consider all the stocks and all the strikes and all the months, heir computers would be doing an awful lot of crunching for nothing most of the time. Might as well concentrate the CPU cycles on the high volume stuff.

-ERD50

twaddle · 01-25-2008, 05:21 PM

That's sort of my guess, too. But I don't think they do it for efficiency. I think they do it because they're hoping to get away with the lower bid as long as they can. Once a higher bid comes in that is within their spread threshold, then they reset.

Bottom-line: I want to be a market maker. Where do I sign up?

kumquat · 01-25-2008, 06:43 PM

Tinfoil hats for sale! Contact kumquat at conspiracy dot net

.

twaddle · 01-25-2008, 06:56 PM

Huh? Do people think market makers are mythical creatures or something? They provide liquidity and make money from the spread. A necessary evil, not a UFO.

terminator · 01-25-2008, 09:26 PM

Since we're on the topic, do large brokerages, like Fidelity, set up systems to trade shares in-house and either save their customers the spread or make more money for themselves? It seems like it would be easy enough for them to net their own orders and only use the market makers for any overages/underages.

brewer12345 · 01-25-2008, 09:58 PM

Welcome to the wonderful world of options. Now bend over, please. It will be less painful that way.

Sometimes I will put in a limit order and see if I get a response. Usually I am subjected to the same BS you got. Then I will cancel the order and wait a couple minutes. The I will stick in a limit order a nickel or a dime higher than my last order. Sometimes that does it, sometimes i have to walk my price up further.

Its a hoot to play options in this sector, isn't it? Volatile like heck and trades more on idiot sentiment than fundamentals.

Maurice · 01-26-2008, 07:53 AM

Options markets are about 10-15 years behind the equity markets in terms of fairness to the retail investor.

If you entered an order (assuming it was not an odd lot) in the Nasdaq that was superior to the NBBO (national best bid or offer), your bid would take precedence and would get executed with time priority, so even if other market makers (or investors via ECNs) matched you they would not step in front of you.

Not so in the options markets.

ERD50 · 01-26-2008, 10:15 AM

Quote:

Originally Posted by terminator

Since we're on the topic, do large brokerages, like Fidelity, set up systems to trade shares in-house and either save their customers the spread or make more money for themselves? It seems like it would be easy enough for them to net their own orders and only use the market makers for any overages/underages.

I wonder this too. It seems like I have had a trade get executed, but I don't even see it on the streaming quotes. I figured that it got settled off the floor? IIRC, this would seem more likely to happen if I put a limit order in right in the middle of the ask/bid spread.

I avoid trading options with a very wide spread - and I can't say that I've noticed anything 'fishy' going on. But I normally don't try to get too greedy. If I'm selling and I think the current price is something I want, I'll put the limit order in the middle or close to the bid, and I usually get filled unless the price is dropping with the underlying. If I REALLY want to sell, I'll put the limit right at the bid. If I'm 'gambling' that the price will jump around, I'll set it higher and take a chance of getting filled.

If this volatility keeps up, and the markets actually stay in a fairly narrow range, selling options can be profitable - there are some rich premiums out there.

-ERD50

01-25-2008, 02:06 PM	#3
twaddle Thinks s/he gets paid by the post Join Date: Jun 2006 Posts: 1,377	Two part question on the how: 1) They obviously have some automated tool to adjust bids whenever a new bid comes in. Where do I get such a tool, and are they adjusting because they know their bid is below fair value? 2) How do they jump in front of me in the queue (or does it just look that way)? I would have assumed that the first high bid would be at the front of the line for any incoming sales. __________________ Favorite ERF quote: "I'm not going to waste my time on someone who's more interested in being stubborn or obtuse or intolerant." -- Nords Favorite ERF error message: "Sorry Nords is a moderator/admin and you are not allowed to ignore him or her."

01-25-2008, 02:46 PM	#8
twaddle Thinks s/he gets paid by the post Join Date: Jun 2006 Posts: 1,377	Hmm, good question, but I don't want to cancel since I got a partial fill. Next time, I'll experiment a bit. Hmm, maybe I can manipulate them by submitting a bogus ask and then following up with a real bid when they all shift to my ask. __________________ Favorite ERF quote: "I'm not going to waste my time on someone who's more interested in being stubborn or obtuse or intolerant." -- Nords Favorite ERF error message: "Sorry Nords is a moderator/admin and you are not allowed to ignore him or her."

01-25-2008, 02:59 PM	#12
twaddle Thinks s/he gets paid by the post Join Date: Jun 2006 Posts: 1,377	Yes, they do that as well, but this isn't the first time I've seen them move as soon as I place a bid. And they don't all move, so they seem to have different thresholds. __________________ Favorite ERF quote: "I'm not going to waste my time on someone who's more interested in being stubborn or obtuse or intolerant." -- Nords Favorite ERF error message: "Sorry Nords is a moderator/admin and you are not allowed to ignore him or her."

01-25-2008, 05:21 PM	#14
twaddle Thinks s/he gets paid by the post Join Date: Jun 2006 Posts: 1,377	That's sort of my guess, too. But I don't think they do it for efficiency. I think they do it because they're hoping to get away with the lower bid as long as they can. Once a higher bid comes in that is within their spread threshold, then they reset. Bottom-line: I want to be a market maker. Where do I sign up? __________________ Favorite ERF quote: "I'm not going to waste my time on someone who's more interested in being stubborn or obtuse or intolerant." -- Nords Favorite ERF error message: "Sorry Nords is a moderator/admin and you are not allowed to ignore him or her."

01-25-2008, 06:43 PM	#15
kumquat Full time employment: Posting here. Join Date: Nov 2005 Posts: 836	Tinfoil hats for sale! Contact kumquat at conspiracy dot net . __________________ Life's a bitch and then you come back - Hindu proverb

01-25-2008, 01:51 PM	#1
twaddle Thinks s/he gets paid by the post Join Date: Jun 2006 Posts: 1,377	How do market makers work? So I made a small fortune selling June-30 EGLE calls a while back, and I figure now looks like an OK time to cover. Basically zero volume today, but the market makers are sitting there with bids at 0.35 and asks at 0.60. I put in a bid at 0.40, and all of the market makers immediately adjust their bid to match mine, and it looks like they jump ahead of me in the queue. How and why do they do that? __________________ Favorite ERF quote: "I'm not going to waste my time on someone who's more interested in being stubborn or obtuse or intolerant." -- Nords Favorite ERF error message: "Sorry Nords is a moderator/admin and you are not allowed to ignore him or her."

01-25-2008, 02:18 PM	#4
FIRE'd@51 Thinks s/he gets paid by the post Join Date: Aug 2006 Posts: 1,074	My broker's option quote shows the bid/offer but not the bid/offer sizes. I think you may be seeing your own bid.

01-25-2008, 02:49 PM	#9
clifp Thinks s/he gets paid by the post Join Date: Oct 2006 Posts: 2,177	Looking at the L2 quotes I see all the exchanges show a bid of $.40 and the asks varying between .55 and .70. To answer your original question. I believe (but do not KNOW) that there are computerized programs that do automatic adjustments. So if the theoritical price of the option $.50 but the best bid $.35 they'll match the best bids as long as it is below .$50. As far as how the priorities are set who's .40 bid gets accepted. Last I asked the Schwab guys to explain this the basic answer I got was it is really complicated. I think that means the little guy gets screwed but perhaps only a little

01-25-2008, 05:16 PM	#13
ERD50 Thinks s/he gets paid by the post Join Date: Sep 2005 Location: Northern IL Posts: 3,694	Just a guess, but on low volume options, maybe their software is not updating as often? But then maybe the calculation gets re-prioritized whenever there is a new bid or ask placed? If I was writing the algorithms, I'd probably do something like that. When you consider all the stocks and all the strikes and all the months, heir computers would be doing an awful lot of crunching for nothing most of the time. Might as well concentrate the CPU cycles on the high volume stuff. -ERD50

01-25-2008, 06:56 PM	#16
twaddle Thinks s/he gets paid by the post Join Date: Jun 2006 Posts: 1,377	Huh? Do people think market makers are mythical creatures or something? They provide liquidity and make money from the spread. A necessary evil, not a UFO. __________________ Favorite ERF quote: "I'm not going to waste my time on someone who's more interested in being stubborn or obtuse or intolerant." -- Nords Favorite ERF error message: "Sorry Nords is a moderator/admin and you are not allowed to ignore him or her."

01-25-2008, 09:26 PM	#17
terminator Recycles dryer sheets Join Date: May 2006 Posts: 219	Since we're on the topic, do large brokerages, like Fidelity, set up systems to trade shares in-house and either save their customers the spread or make more money for themselves? It seems like it would be easy enough for them to net their own orders and only use the market makers for any overages/underages.

01-25-2008, 09:58 PM	#18
brewer12345 Give me a museum and I'll fill it. (Picasso) Give me a forum ... Join Date: Mar 2003 Posts: 9,255	Welcome to the wonderful world of options. Now bend over, please. It will be less painful that way. Sometimes I will put in a limit order and see if I get a response. Usually I am subjected to the same BS you got. Then I will cancel the order and wait a couple minutes. The I will stick in a limit order a nickel or a dime higher than my last order. Sometimes that does it, sometimes i have to walk my price up further. Its a hoot to play options in this sector, isn't it? Volatile like heck and trades more on idiot sentiment than fundamentals. __________________ “When you realize that you are one of the rare few who observe moral principles in their relationships with others, there is a temptation to sink into amorality, not out of conviction or pleasure but simply to avoid further pain, because there is no greater suffering than being an angel in hell, whereas a devil feels at home wherever he goes.” – Martin Page, How I Became Stupid

01-26-2008, 07:53 AM	#19
Maurice Recycles dryer sheets Join Date: Oct 2007 Location: New York Posts: 391	Options markets are about 10-15 years behind the equity markets in terms of fairness to the retail investor. If you entered an order (assuming it was not an odd lot) in the Nasdaq that was superior to the NBBO (national best bid or offer), your bid would take precedence and would get executed with time priority, so even if other market makers (or investors via ECNs) matched you they would not step in front of you. Not so in the options markets. __________________ Money's just something you need in case you don't die tomorrow.