by Chris Verhaegh
Market Maker’s use this knowledge to their advantage through a formula I call the “Market Maker’s Hedge”.
Let’s say we have a stock priced at $100. The $100 Call is priced at $2/$3 Bid/Ask and the $100 Put is priced at $2/$3. Let’s assume the Market Maker buys from retail traders at Bid and sells to them at Ask. If he buys at $2 and sells at $3 he makes a buck.
Here’s where it works really well for the Market Maker. He doesn’t have to sell the same option he buys or buy the same option he sells to make that dollar. He could buy a Call for $2 and Sell a Put for $3 and make it. Or he can buy a Put for $2 and sell the Call for $3 and make it. They just buy or sell stock to make it all work.
First let me share with you the “Formula” as I learned it and then how I should have.
C = S + P
(Call = Stock + Put)
Using this formula, the Market Maker could buy the stock at $100 and the Put at Bid ($100 + $2 = $102) then sell the Call at Ask ($3) for a total of $99. If the market moves up and the owner of the Call exercises it, the Market Maker then sells the stock he has and he keeps his $1 profit. If the market moves down, he exercises his Put, sells his stock and keeps the $1 difference. No matter what happens, he pockets a buck.
This is the best formula I have earned. In actuality, the more accurate the formula is C = (S – SP) + P, where SP is the strike price. Since the stock price minus the strike price give us Intrinsic Value, we could express the formula this way:
C = I + P
(Call = Intrinsic + Put)
Either formula you use should work fine. One is a little more accurate, but the other is easier to calculate. We could call (C = S + P) the Quick version, and (C = I + P) the Expanded version.
The point is that it doesn’t matter which way the stock moves, the Market Maker will make his money. If there were a bias to option pricing, you would see one option more expensive than the other. Calls would be expensive if the market felt that the stock was going unquestionably higher.
*These assumptions assume the stock will not pay a dividend before expiration. In instances where stocks pay a dividend, you will see lower Call prices and higher Put prices.
If the market anticipated movement, one direction or the other, the Market Maker’s Hedge would not work. The Put/Call parity keeps the Market Maker’s Hedge equally profitable regardless of market direction.
Another way to put it is: option pricing formulas assume stock price direction is a coin toss. Assuming you don’t have a coin with two heads or two tails, flipping it has an equal probability of either side landing up. In the Law of Large Numbers, 50% of flips should land one side up, 50% on the other side. If someone were to wager on coin tosses, the payout should equal the risk. But this is not calling-it-in-the-air coin tossing. This is Weekly options trading, so the reward can be much greater than the risk.
Besides the farmers, most Idahoans can share what the water year will be like. It directly affects recreation, river flows and reservoir levels. Farmers know that with a big snow melt, their allocations of water delivery allow them to grow the much more valuable (and thirsty) mint, rather than other less valuable crops. The principle is pretty simple: no water, no mint. Water in the reservoirs means water in the canals. Water in the canals means water in the fields. Water in the fields means money in the bank for Idahoans.
What does this have to do with trading? The farmers know when they will make more money. The truck and tractor sellers know when they will make more sales. It’s a trickle-down effect from the trickling-down of the melting snow. We as traders might not know the specifics of what’s in store, but we can read our “snow-pack” levels and look forward to profiting from a directional bias. We just need to plan ahead.