One way to better understand options is by viewing them through the eyes of an option market maker.
We did that a month ago…
We discussed how exchanges employ market makers to, as their name implies, “make a market.”
They provide liquidity by quoting bid and offer prices on a range of call and put options. That way, traders can readily enter and exit positions.
One of the key themes we looked at then was the impact volatility has on market makers’ risk. That also affects the price they charge for option premiums.
Today, I want to delve into how market makers hedge that risk.
That can help you understand options more fully – and become a better trader…
Taking on Obligations
Let’s begin where most folks do when they’re getting started with options – buying a call option…
When you buy a call option, you’re betting that the value of the underlying asset will rise.
If the stock price rises before the option expires, you can generate a tidy profit.
By buying the call option, you gain a right. You can buy shares at the option’s strike price by exercising the option before it expires.
The key point here is that it’s your choice. By paying the premium to the market maker, you get to choose what to do.
What if the share price trades sideways or falls and your call option expires worthless? Then the market maker gets to keep the premium.
Doing this multiple times over numerous stocks is how they make their money.
By receiving that premium, however, the market maker takes on an obligation.
If the call option buyer decides to exercise their option, the market maker must hand over the shares at the option’s strike price.
If they sell a call option with a $100 strike price, they must hand over the shares at that price.
That’s the case even if the stock skyrockets to $200, $300, or much higher…
You can see that it would only take one massive rally to put the market maker out of the game. We saw a rally like that happen with Nvidia (NVDA) in the AI boom.
So the market maker might also take out the opposite position to protect themselves.
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Hedging the Bets
Let’s stick with our NVDA example… especially given that earnings are due out on Wednesday.
NVDA is trading around $130. So let’s say I decide to buy a call option with a $130 strike price. (Please note that this is not a trade recommendation.)
If NVDA’s earnings surprise to the upside, the stock could surge upward. Then I can exercise the option and pay $130 per share for 100 shares of NVDA.
If the stock is trading at $140, for example, I can immediately turn around and sell my new shares for a profit.
But what if I’m wrong and earnings disappoint, sending the stock sharply lower?
Then the most I can lose is the premium I paid for the call option.
But consider the market maker. They must be able to hedge their position to cover any risks… especially if NVDA gaps higher.
One way the market makers can protect themselves is by buying NVDA shares at the same time.
That way, they’re covered no matter how high the NVDA price goes… and can fulfill their obligations if a buyer exercises their options contract.
But something is missing…
Adding Another Leg
If the NVDA stock price tanks, the market maker is going to lose money on their shares. Theoretically, those shares could go all the way to zero.
That’s why the market maker needs to add another leg to their position – a bought put option.
Remember, a put option gives the buyer the right to sell shares for the strike price.
So the market maker sold a call option at $130 and bought 100 NVDA shares at $130.
Then they also need to buy a $130 put option to complete their hedging strategy.
Even if NVDA falls, they can exercise their put option to sell their shares for $130 per share.
That way, they’re covered whatever the share price does.
This is just one way market makers hedge their positions, of course.
But it’s important to understand how this relationship works.
By following the dynamics of the options market, you gain a better understanding of how the different pieces fit together.
And that helps you become a better options trader.
Happy Trading,
Larry Benedict
Editor, Trading With Larry Benedict