Hedges and Market Makers

Last week I wrote about one way to “hedge,” or reduce the risk of a particular kind of option trade by adding another option. Let’s look into this idea a little further.

First of all, the term “hedging,” as in “hedging one’s bets,” has been in use since at least the 1600′s in England, according to this source: http://www.phrases.org.uk/meanings/hedge-your-bets.html

It derives from the idea of actually planting a hedge, to prevent loss due to escaping livestock. I also can’t resist including this excerpt, which explains the term “stock”:

“Curiously, the original examples of another financial device … that is, stocks, were literally made from material that was taken from hedges. In the 17th century, the tally that recorded a payment to the English Exchequer was a rough stick of about an inch in diameter, split along its length. One half, the stock, was given as a receipt to the person making the payment; the other half, the counterfoil, was kept by the Exchequer. Ownership of payments that were made jointly by a group were shared among the members of so-called joint stock companies, hence stocks and shares. ”

In financial terms, a hedge is created by adding another position to the original position, to reduce its risk.

Now let’s look at the idea of a “market maker.”

In general, a market maker is someone in the business of buying and selling the same product. He is a middleman – not a producer of the product, nor a consumer of it. He is willing to buy from all comers at a certain (wholesale) price, and to sell to all comers at a higher (retail) price.

In one of my college economics classes, the watermelon market was used as an example of a market free from monopolistic influence. There are so many watermelon vendors that no one of them can affect the market price. And there are so many buyers that no one of them alone can affect the price either.

Some years after college, when I owned an IT consulting company, I had a client who coincidentally was a market maker in watermelons. That company posted every day the prices that they would pay for watermelons of each type and grade. Anybody who showed up at the loading dock with a truckload of watermelons could sell them to the company at the posted price.

Meanwhile, the company’s salespeople were on the phones talking to grocery chains and restaurants, selling them watermelons at higher prices. And if a truck showed up at the dock and wanted a load of watermelons, they could buy them at the posted sale prices. The watermelon man had a risk of a large movement in the price of watermelons that might happen while he held them in inventory. His main protection was that he held very little inventory at any one time. (One does not buy and hold a watermelon for the long term).

Yikes, what does this have to do with trading or options?

Well, in the option world, there are market makers too. These are specialized traders whose business is to buy and sell the options of a particular stock, or group of stocks. The option market makers have a tool available to them that my watermelon-selling client did not. Option market makers can hedge their “inventory” in a particular way, and that is by simultaneously holding a position in the stock itself.

Every time an option market maker sells a call option to a trader, he has received a finite amount of money for something that has potentially unlimited profit for the customer. Whatever profit the customer makes, however, comes directly out of the pocket of the market maker.

And whenever the market maker lets a customer sell a call option to him, he, the market maker, now owns an instrument with unlimited profit. If the market maker had an equal number of long calls and short calls, his risks and rewards would balance out. His profit would become just the difference between the amounts he received for selling calls at retail, and the amounts that he paid when he bought them at wholesale. The same is true in reverse for put options.

In fact, that is what the market maker wants. He is in business for the sure profits on the wholesale-retail spread. He does not really want to deal with the changes in prices of the products in his “inventory.”

To that end, to be perfectly hedged, the option market maker uses the stock itself to offset the risk on his option positions. Each option position can be translated into an equivalent number of shares of stock. Every time a market maker sells a call to a customer, he buys a number of shares of the underlying stock such that the profits on the stock and the short call exactly offset each other. When he buys a call, he sells stock. When he sells a put, he sells stock, and when he buys a put, he buys stock. At all times, his net stock position equals and offsets his net option position. He does not care what the price of the stock does. The tool that lets the market maker know how many shares of stock are required for each option is the calculation called Delta, which is one of the products of the option pricing model, or formula.

Having this model, and therefore a way to hedge away a market maker’s price risk, is a big part of what makes it attractive for people to go into that business. For those of us who make some or all of our income from trading options, that is a good thing – without market makers, there could be no option market. Thanks to that, we have the huge variety of option opportunities that exist today – including creating hedges of our own.

Next time, more ways to do just that.

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