by Chris Verhaegh

What happens when you place an order to trade options?  Who’s on the other side of your trade?  How do you know you can sell your option after it’s risen in price?

Many online stock traders venture into online option trading only to discover new terms… truly confusing terms.

Sometimes the best way to understand option trading is to first be familiar with stock trading.  I am not referring to timing, but the mechanics behind the trades.  As complex as stocks are, they pale in comparison to the option labyrinth.

Option Market Makers are like a blend of the NYSE Specialist and the NASDAQ Market Maker.  Options trade on an actual exchange like the NYSE, but Market Makers offer liquidity with ready Bids and Asks.  The major difference lies in the number of possibilities.  You either buy stock or you sell it.  Option trades include both buying and selling both puts and calls, with countless strike price choices.

Option Market Makers don’t start with a large inventory, they create the option contracts as buyers and sellers appear.  They would just as soon not ever own stock.  If they do, it means buyers and sellers of options are not in equal proportion.  Their profit comes from buying at bid and selling at ask, the Bid/Ask spread.  Option Market Makers buy and sell numerous option contracts, not always the same ones.  Through the use of Delta, Market Makers and option traders are able to remain basically market neutral or completely hedged.

Delta is a measure of change in an option compared to the change in the underlying.  Delta is also the measurement of relativism between option contracts.  This relativism is what Market Makers use to hedge.  They try to remain at Zero – Neutral.

To show how Market Makers trade Delta Neutral, let’s make some assumptions.  Let’s say an In-the-Money (IM) call has a Delta of .75, an At-the-Money (ATM) call has a Delta of .50, and an Out-of-the-Money (OTM) call a Delta of .25.  If a retail investor buys an ATM call from the Market Maker, the Market Maker is now short a Delta of 50.  Remember that 100 shares per contract, means .50 x 100, so the decimal is dropped.  If someone then sells two OTM calls to the Market Maker, the Market Maker is then buying a total Delta of 50.  So selling -50 Deltas and buying +50 Deltas, equals zero Deltas.  Delta Neutral.  A snapshot risk free trade.  Snapshot, meaning at the instant the trade takes place.  Technically, the risk is the Gamma, the change of Delta.

Puts are measured in negative Deltas.  This can be quite confusing.  Delta measures the change in the option versus the upward movement of the underlying stock.  So if your stock moves higher, the Put would move lower.  Disturbing as it seems, two negatives make a positive.  If the stock price drops, with a negative Delta, the Put option increases.

Selling a Call option with a Delta of .50 and buying a Put option with a Delta of -.50, the net effect is zero.  Buy 20 options with Delta of .75 sell 60 contracts with a Delta of .25, Neutral.  Long 20 contracts with a Delta of .75 = + 15000, selling 60 times .25 = -15000.  15000 minus 15000 equal nothing.  Hedged.

The only problem is Delta can change.  Market Makers adjust constantly, but they enter trades as snapshots.  Whether you place your order via the computer or phone, it’s your broker who sends it to the trading floor.  In addition to electronic exchanges, stock options trade at four physical exchanges; the Chicago Board of Options Exchange (CBOE), the Philadelphia Stock Exchange (PHLX), the American Stock Exchange (AMEX), and the Pacific Stock Exchange (PSE).

The options for most stocks used to trade at only one exchange.  However, many now trade at multiple exchanges.  Few online brokers allow trades to be routed to a particular exchange.  If trading over the phone, you should be able to direct your order to a specific exchange.

Why does routing matter?  The Bid/Ask spreads may vary.  As an example, one exchange might bid $.025 ask $0.45, another bid $0.30 ask $0.50.  If your broker automatically sends an order to a primary exchange you could pay too much or sell too low.  Using the highest bid and the lowest ask effectively tightens the spread.

An obvious question is why do different exchanges have different price quotes?  Answer: Different Market Makers.

Option premiums act like pari-mutuel bets.  More action one way or another changes premiums.  If everyone wants to buy options, premiums rise.  If all the players want to sell, premiums drop.  Parimutuel betting (from the French language) is a betting system in which all bets of a particular type are placed together in a pool; taxes and a house take are removed, and payoff odds are calculated by sharing the pool among all placed bets.

Think of option Market Makers as dealers.  They match buyers and sellers as bettors for and against.  They skim the pot by taking the bid/ask spread.  But also think of them as players.  If two retail trades can’t match up, they’re there to be on the other side.  No matter which side that is.

Market Makers are floor traders who either are exchange members or rent their seats from exchange members.  Seats rent for about $10,000 or more a month and are valued around $600,000.  What do they get for all that money?  The right to make the difference between bid and ask.  Known in the industry as “picking up nickels in front of bulldozers.”

Exchange rules require them to make a two way market.  If they bid, they must offer.  If they want to sell, they must be willing to buy.  Their quotes must be good for a minimum of 10 contracts.  These rules guarantee the presence of buyers when you want to sell, and sellers when you want to buy. 

If you send an order for 10 contracts or less to sell at the bid price, or a buy at ask, your order never makes it to the trading floor.  It is filled electronically via the retail automatic execution system (RAES).  Market orders for 10 or less contracts are filled this way.  All other orders go to the floor.  These orders include; orders inside the Bid/Ask spread, orders outside the Bid/Ask spread, contingent orders, and large orders.  If you send in large market orders, beware, Market Makers can adjust their quotes after the initial 10 and you’ve shown your cards.  Contingent orders imply a “this or that.”  Such as, “Buy 50, minimum 20,” “fill or kill,” “All or none”, or “Immediate or cancel.”

As a retail client, paying commissions, you have some advantages.  Your order is known as a customer order.  Exchange member orders are called firm orders.  In many situations customer orders take precedence.  Only non-contingency retail orders, so don’t unnecessarily add contingencies.  You can place your order outside the Bid/Ask spread, meaning you want to sell for higher than the lowest ask price, or buy for lower than the lowest bid price.

If the market moves in the right direction, your order takes precedence to firm orders.  You become the high bid, or low offer.  You won’t be filled unless the market moves, and someone wants to take the other side of the trade.  If successful, you’ve avoided losing the Bid/Ask spread.  Your cost to trade is now lower.  This allows aggressive retail traders to imitate Market Makers without the expense and obligations.  They are known in the industry as “scalpers.”  Market Makers don’t want you to know you have the keys to the “bulldozer.”  If you enter a price inside the spread, the Market Makers either need to fill or match.  They allow you to become the market or they “buy your silence.”

A fun game to play requires a good quote system, a fast broker and a slow stock, you can watch as you toggle the prices up and down.  This knowledge gives a tremendous advantage to the experienced option trader and valuable insight to the novice.  Little tricks of the trade like picking up a nickel can certainly add up to pay commission.  This is one of the tricks full service brokers use to get better fills.  Is their higher commission justified when you can do it on your own?