How do market makers work?

[twaddle]

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]

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]

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]

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]

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]

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]

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]

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]

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]

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]

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]

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]

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]

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]

Tinfoil hats for sale! Contact kumquat at conspiracy dot net .

 

[twaddle]

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]

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]

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]

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]

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

 

[CyclingInvestor]

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?

Yes. Orders are always crossed internally if they can, but they must match the
composite BBO price.

 

[clifp]

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?

Googling a bit I see you can get a seat on the Chicago Board of Trade for a bit over $3 million, and CBOT website says you need to pass a few tests.

IIRC, the CBOT is one of the few remaining hold outs of the open auction system, which means you'd have a good excuse to dress up in bright guady cloths wear weird hats and such.

I think it would fun but I hear others a say it is a lot of w*rk

 

[al_bundy]

i remember reading Cramer's book when thestreet.com went public he said Knight Capital was a market maker. he said they bought up the stock and then shorted it or something like that. forgot the details.

in the end though they made a ton of money and the suckers who bought the IPO lost a lot of money