Trading Flat
Most market makers like to trade flat—that is, profit from the bid-ask
spread and strive to lower exposure to direction, time, volatility, and interest
as much as possible. But market makers are at the mercy of customer
orders, or paper, as it’s known in the industry. If someone sells, say, the
March 75 calls to a market maker at the bid, the best-case scenario is that
moments later someone else buys the same number of the same calls—the
March 75s, in this case—from that same market maker at the offer. This is
locking in a profit.
Unfortunately, this scenario seldom plays out this way. In my seven years
as a market maker, I can count on one hand the number of times the option
gods smiled upon me in such a way as to allow me to immediately scalp an
option. Sometimes, the same option will not trade again for a week or
longer. Very low-volume options trade “by appointment only.” A market
maker trading illiquid options may hold the position until it expires, having
no chance to get out at a reasonable price, often taking a loss on the trade.
More typically, if a market maker buys an option, he must sell a different
option to lessen the overall position risk. The skills these traders master are
to lower bids and offers on options when they are long gamma and/or vega
and to raise bids and offers on options when they are short gamma and/or
vega. This raising and lowering of markets is done to manage risk.
Effectively, this is your standard high school economics supply-and-
demand curves in living color. When the market demands (buys) all the
options that are supplied (offered) at a certain price, the price rises. When
the market supplies (sells) all the options demanded (bid) at a price level,
the price falls. The catalyst of supply and demand is the market maker and
his risk tolerance. But instead of the supply and demand for individual
options, it is supply and demand for gamma, theta, and vega. This is trading
option greeks.