Although technology has forever changed the way options trade, the market maker's basic function hasn't changed: to create liquidity for potential buyers and sellers. Market makers attempt to generate profits from the spread between the bid price and the ask price. The bid prices need to be low enough and the ask prices high enough so that if an option is bought or sold at a given price, the market maker can squeeze out a profit on the trade.
Of course, if the markets are too "wide"—with the bid and ask too far apart—it’s likely no one will want to place the trade. Deciding the optimal spread to attract buying and selling while also earning a profit is the balance any market maker needs to strike.
Order flow and liquidity, for both the underlying stock and its options, are generally the two most important determinants of bid/ask spreads. Increasing order flow and greater volume means more buyers and sellers generating bids and asks. Therefore, stocks and options that attract the most participants tend to have the narrowest bid-ask spreads. From the market maker's point of view, the volatility of the underlying stock is an important consideration as well.
Often bid/ask options spreads widen when the underlying stock begins to see heightened volatility—like when a stock moves $3 in one day when it usually only moves $0.20. The reason the bid/ask options spread gets wider often has to do with how market makers manage the risks to their respective options positions and trades. Market makers typically don't speculate on where the underlying stock price will go. They usually try to limit their exposure to price moves by keeping the delta of their positions close to zero. They do that throughout the day by trading stock against the options they buy or sell. This is called hedging. If a customer sells 10 calls, for example, the market maker buys those calls and hedges the long delta on those calls with short stock.
Consider a 0.30-delta call. The market maker would sell short 300 shares of stock to offset the long 300 deltas from the 10 calls that were purchased. If the price of the stock goes down, the gains on the short stock offset losses on the long calls. If the stock moves up, the gains on the long calls offset the losses on the short stock. As shares move higher and lower, deltas are always changing, and the market maker adjusts their hedges accordingly.
Prior to placing a hedge, the market maker is tracking the stock price to determine what it will cost. If the stock is trading at high volume within a relatively tight range, the market maker is likely to be more confident they can execute a trade at or near that price. They'll likely make narrower bid/ask options spreads to be more competitive with other market makers.
But if the stock price is moving and is quite volatile, the market maker will likely be less confident they can execute the hedge at the desired price. The orders might not get filled until the price has moved. So, market makers generally factor in the slippage (which is the difference between the current stock price and the stock price at the time the market maker hedges their options exposure) from their potential stock trade into the bid/ask spread of the option.
Buying the option at a lower bid price or selling the option at a higher ask price lets the market maker get a slightly worse fill on the stock hedge and still make some money on the trade.
A measure of an options contract's sensitivity to a $1 change in the underlying asset. All else being equal, an option with a 0.50 delta (for example) would gain $0.50 per $1 move up in the underlying. Long calls and short puts have positive (+) deltas, meaning they gain as the underlying gains in value. Long puts and short calls have negative (–) deltas, meaning they gain as the underlying drops in value.
Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Please read the Options Disclosure Document titled Characteristics and Risks of Standardized Options before considering any options transaction. Call Schwab at 800-435-4000 for a current copy. Supporting documentation for any claims or statistical information is available upon request.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.0423-3D8N