Many people envy the bookmaker at the race track, but rarely does anyone give them a thought when the favorites keep winning. So it is with the market makers who seemingly never cease to quote a price.
Market making involves considerable funding abilities. Not only will a clearer demand that margins be funded, but option traders are unfortunately still plagued with many administrative decisions going against the grain of common sense. It is not uncommon for up to 25% of the available funds to be required to remain idle and free of margin commitment. Even if the position in total has very small risk, the number of open positions alone will be margined individually with only a ceremonial discount will be extended in lieu of offsets.
The role of a market maker is to provide all and sundry with the opportunity to participate in the market. For this privilege participants will pay a price, and that will invariably be in favor of the price maker.
As in most asset allocation, the expense of crossing a spread to enter and exit a position is often the one silent expense that balances against other advantages such as low fees, leverage, and even liquidity.
The market maker is not concerned as to what option they are trading, it is the price that an option trades at that is focused upon. Needless to say, every position is hedged immediately, as primarily the market maker is a volatility trader, but one who offsets one position with another, building a portfolio of option positions that is founded on theoretical value.
If a benchmark is provided by the pricing model, and allowances for the nuances of supply and demand are incorporated, a market maker can price any option using a combination of these sometimes competing interests, and take advantage of value. In an uncertain world, theoretical value that is mollified by the rigor of the real world is as close to precise valuation that a human being can get. When a market maker’s price is accepted, if care has been taken in pricing, value is undeniably present.
Of course, part of the market makers task involves adjusting their prices according to the forces of demand and supply at the time; it makes little sense to offer what is a certain buyer, a price that is unreflective of this pertinent knowledge. Accordingly, the benchmark volatility may need to be revised upward if there is pressure from buyers at the time, and conversely if sellers are predominant. In the fullness of time, the market maker will be accepted on the other leg of their price, and so again capture value. It is not the precise values that are of import but the process of quoting prices. If value is achieved in every trade, profit will accrue, and it is upon this principle that the livelihood of the market maker is hinged.