How Market Makers Manage
Delta-Neutral Positions
While market makers are not position traders per se, they are expert
position managers. For the most part, market makers make their living by
buying the bid and selling the offer. In general, they don’t act; they react.
Most of their trades are initiated by taking the other side of what other
people want to do and then managing the risk of the positions they
accumulate.
The business of a market maker is much like that of a casino. A casino
takes the other side of people’s bets and, in the long run, has a statistical
(theoretical) edge. For market makers, because theoretical value resides in
the middle of the bid and the ask, these accommodating trades lead to a
theoretical profit—that is, the market maker buys below theoretical value
and sells above. Actual profit—cold, hard cash you can take to the bank—
is, however, dependent on sound management of the positions that are
accumulated.
My career as a market maker was on the floor of the Chicago Board
Options Exchange (CBOE) from 1998 to 2005. Because, over all, the trades
I made had a theoretical edge, I hoped to trade as many contracts as
possible on my markets without getting too long or too short in any option
series or any of my greeks.
As a result of reacting to order flow, market makers can accumulate a
large number of open option series for each class they trade, resulting in a
single position. For example, Exhibit 16.7 shows a position I had in Ford
Motor Co. (F) options as a market maker.
EXHIBIT 16.7 Market-maker position in Ford Motor Co. options.