No. of Recommendations: 12
The March 15, 370 call currently shows a market of 6.40 by 6.65, is that what you see you or do you see an, inside market? Assuming that's you on the offer , offering say 50 at 6.65, and I'm the MM , and I sell 50 against your order, at 6.60 what's my risk ? Thanks.
Yes, 25 cents is the gap I see on that contract.
Ok, let's assume the bid/ask is 6.40 / 6.65 and you are the market maker.
And I am offering to sell at $6.65 for 50 contracts.
Let's assume the very likely situation that the market maker is also asking at that $6.65 level along side me, since that is the typical spread right now.
(in your example, you as market maker would be the putative buyer at 6.60, not seller)
You (the market maker) won't be a buyer at that $6.65 offer of mine.
Their algorithms calculate what the contract is really worth. In this case, they have decided the right answer is very close to $6.525, the midpoint of THEIR bid and THEIR ask.
That's not using anything to do with stock valuation, but purely based on things like the (aptly named) B-S option pricing model, with perhaps tweaks based on what else they are doing in their portfolio that hour or that day.
Since they figure the contract is "worth" about $6.525 right now, they won't buy from me at $6.65, nor at $6.60.
They also won't buy at $6.55 either--those prices are all higher than what they have decided the contract is worth to them today.
It's highly likely they'd buy from me at $6.45--it's only a nickel above their bid, and these are relatively easy to trade options so they aren't usually very greedy. Perhaps they would hold out and not buy above $6.40, though that's not my usual experience.
To your specific question, the "risk" to them on the idea of being a buyer at $6.60 is that their computers are telling them that this contract is only worth $6.525, so they'd deem themselves to be losing 7.5 cents per share by doing the trade.
Let's continue:
Now, what is the risk that you, the market maker, have taken on as a result of buying this contract from me at (say) $6.45?
They have made a notional profit of 7.5 cents because it is below what their computer estimates the fair value to be, being the midpoint $6.525. So far so good.
But the market maker has just bought a call that is only a little out of the money, so is as a result sort-of long the stock.
I haven't looked up the delta, but let's say it's 0.6.
i.e., if the stock price moves up $0.10 in the next hour, the B-S "fair" option price will move up 60% as much or $0.06.
So, if the market maker has just bought 1 call from me, he will likely immediately short 0.6 times as many shares, 60 shares of BRK/B, to remain market neutral on BRK.
They are in the business of picking up the bid/ask gaps, not in the business of speculating on the direction of stocks.
If you write a whole lot of calls, creating new contracts in the process, you are very likely causing someone else in the market to short a whole lot of stock.
Jim
