Option Investor
Educational Article

The Mechanics of the Market

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In the last segment, we reviewed a common technique utilized by market-makers to evaluate spreads and combination positions. However, many of our readers may not be familiar with the methods these traders use to make a market for the retail options player. Today, we are going to examine this process in greater depth.

In the stock market, specialists are appointed at each exchange to provide liquidity when there is a lack of public orders to buy or sell a particular issue. These traders use funds and collateral holdings from their own inventory to offset existing supply and demand, and they also maintain a list of current orders for the stock. With options, the arrangement is very similar. A professional trader, often called a market-maker (or specialist, floor broker, etc.), either buys or rents a member seat. This affiliation allows the trader to transact business on a "real-time" basis at that exchange and throughout the derivatives markets. He may trade solely for a private account or he may have an agreement with the exchange to make a market in the options of a particular issue. In either case, he hopes to profit from the difference in the bid/ask spread. Although some exchanges have more than one market-maker for each optionable issue, their combined objective is to provide bids and offers in the absence of public orders.

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