Option Investor
Trader's Corner

A Conundrum Resolved

Printer friendly version

As new options traders, we dutifully trudge through descriptions about pricing models. We learn to reel off the words "Black-Scholes model." Some of us merely scan descriptions of the model, learning that option prices vary with strike price, the underlying's price, the time left until expiration, interest rates, dividends and volatility.

Many find their eyes glazing over and their brains shutting down after the first three or four such parameters. Some more persistent and mathematically inclined options traders actually study the model, going to CBOE's website or iVolatility's (www.cboe.com and www.ivotality.com). They methodically input various values for those parameters, developing a feel for the way an option's price might change as each of those parameters varies. So, most of us, whether we want to try calculating options prices or not, understand that there's a mathematical value that can be obtained once each of those parameters are set.

However, sooner or later, most options traders are going to hit upon a conundrum when they're thinking about options pricing. We know that any market, even an options market, is also driven by supply and demand. So, what determines the price of an option: a mathematical model such as the Black-Scholes model or good old supply and demand? Why do we even need a model if supply and demand are going to determine price?

Recently, a puzzled trader asked the same question of the CBOE's Options Institute's "Ask the Institute" staff. Which determines options prices? The Institute's answer: Both.

The CBOE is an exchange, just as the Philadelphia Stock Exchange and the American Stock Exchange are exchanges. The CBOE does not set the prices. Instead, for all equity options and some index options, a Designated Primary Market-Maker or DPM serves in the category that many of us would think of as a specialist. This person makes the market for a designated equity's options, for example. If a person such as the DPM were working at another exchange, that person might be called PMM or LMM, as in Lead Market Maker. The DPM works with options that are traded on the Hybrid system at the CBOE. Other options not traded on the Hybrid system might be represented by independent market makers.

On the CBOE, the DPM must make a continuous bid and ask prices for all the option series in that DPM's designated series of options. That's where the mathematical models come into play. The mathematical model helps the DPM determine a theoretical or "fair value" for the bid and ask for a particular option. (Note: "Fair value" is a term that can have many meanings in the trading world. This particular one is not the fair value you hear referenced on CNBC, for example.) DPM's also use their own experience to help guide the market they'll make for those options and the prices they'll set.

Other traders on the floor are deciding what they want to pay to buy or capture to sell, while you, at your computers, are also deciding what you think a fair value would be for that option. You're looking at the bid and ask the DPM has determined, but you're probably not wanting to sell exactly at the bid or buy exactly at the ask. You want a little better deal than that. So, orders start streaming in. For example, maybe you want to sell a RUT option you bought, but for more than the bid, and your neighbor down the street just happens to want to buy that same option at the same time, but at less than the ask. You both put your limit orders in through your online broker, and those orders are inside the bid and ask determined by the DPM. And so it goes. Supply and demand begin to change the original bid and ask that the DPM calculated.

If you and your neighbor compare notes later and you find that you sold your option at the same time your neighbor was buying it, and for the same price, you might be tempted to conclude you had sold your option directly to your neighbor. Funny story, but that's not technically true. You might also conclude that the DPM handled the sell. Maybe not true, either.

When you sell your option, you're selling it to the Options Clearing Corporation or OCC. When your neighbor bought it, your neighbor also bought it from the OCC. The OCC was established in 1975 and is the counterparty to options transactions. Options contracts are standardized contracts, so you're not physically selling your contract to your neighbor or to the DPM.

Also, in this hybrid system that includes the DPM, floor traders and orders received from individuals and others via their brokerage firms, either electronically or otherwise, the DPM may not handle the transaction. Your electronic order to sell may indeed match up with your neighbor's order to buy, and the order may be processed instantaneously and electronically without the involvement of the DPM.

Controversy remains about the role of DPM's and other market-makers. In the days before electronic trading, they were needed to create an orderly market, but they sometimes required an extended period of time before all calculations could be made, so sometimes a bit of time expired before all options opened at the start of the trading day. Now computers can perform those calculations in seconds. Some believe the day of the specialist of any stripe is dated, while others believe these market-makers perform a vital role. Discussing that topic is not the thrust of this article, however.

Your brokerage might be serving as a DPM for one or more appointed options. If you want to know, you can ask your broker, or you can check the symbol directory at www.cboe.com. That directory lists the DPM for each stock option.

The CBOE advertises now and then for new DPM's, as it did early in 2005 when it was seeking DPM's for Russell Index Market-Makers. DPM's must have deep pockets and lots of options-trading experience. Requirements also include providing continuous bids for 75 percent of the available trading hours in each calendar month, providing an average bid/ask spread of no more than $0.40 over a calendar month, and responding within ten seconds in some cases.

DPM's start the ball rolling each day by using a model such as the Black-Scholes model to calculate theoretical prices and to keep prices roughly in line during the day, but then the prices the DPM sets are acted upon by regular old supply and demand. Conundrum resolved.

Trader's Corner Archives