One critical aspect of the options exchange is liquidity, which signifies the ease of buying and selling options. Having liquid markets is key to many things, including facilitating long-term trading positions which are viable for most investors. One crucial aspect of providing liquidity in the listed options market is the market makers.
Who are Options Market Makers?
A market maker is a professional contracted by banks, brokerage firms, and other financial institutions to keep the options exchanges running effectively by maintaining liquidity. They are highly skilled with excellent analytical skills and acumen. Furthermore, they have to understand the flow of the market and analyze it at the same time.
What Roles Do Market Makers Play?
A market maker enables buyers and sellers of a particular security to transact at mutually agreeable prices in any securities market. This role may be performed by an individual, a human or computer algorithm, or a firm that automatically generates orders to buy and sell to maintain a two-way price of a stock. In the context of options trading, the market makers facilitate liquidity in the market. The liquidity risk faced by market makers is ultimately the risk of not fulfilling an obligation at its specified settlement price because it lacks enough liquidity or cannot borrow it when needed.
How Listed Options Market Makers Operate?
A market maker undertakes every trade in any security exchange market. He is the party that stands on the other side of the trade. For example, if you are looking to sell your shares at a market price higher than their current value but a stockbroker wants to buy them for a lower price, you need an intermediary to undertake the other part of the deal. Here is where the market maker comes in and wards off any financial issues arising from this transaction.
A market maker is a centralized source for order execution. A market maker can serve customers differently, including acting as a passive liquidity provider, displaying quotes only when there are indications of interest, or even charging customers for order flow.
Market makers keep the markets working by taking bids and offers and putting them together into completed trades. They do this by matching buy and sell orders. The bid is the price the buyer is willing to pay, and the offer is the price the seller is willing to accept. The job of a market maker is to match a buyer’s bid to a seller’s offer. If the market maker finds a match between a buyer’s bid and a seller’s offer, then the trade is complete, and they earn their income from the difference between the bid and offer.
How Options Market Makers Earn Profits
A market maker is a commission-based broker who provides liquidity for financial instruments in the equity, options, and futures markets. They act as a counterparty to each trade and use their capital to purchase and sell all the securities and derivatives their clients demand.
As a reward for their troubles, they enjoy the privilege of earning profits from the spreads of every transaction. Options are priced in exchanges depending on the asking price and the bid price. Thus, an investor buying contract would pay a higher price than what the seller would receive. The variance of the ask price and the bid price is the spread or market maker’s profit.
Market makers make money in two ways. If their guess is correct, the spread is negative, and the market maker earns commissions on the trades it places. If their guess is wrong, the spread is positive, and the market maker makes money by shorting the security.
However, the market maker needs to position himself strategically to avoid risks of losses despite the advantages of spread.
A market maker is a financial institution or an independent broker and is essentially a middleman between the buyer and the seller in a given security. Their job is to maintain liquidity in any given trade by buying and selling options or stocks continuously.
Market makers are a vital link that makes markets more liquid and volatile and provides even greater profits for the small traders. It is worth noting that market makers aren’t competing against day traders. As such, they can be more like allies on your quest for a successful option picking.