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What Retail Traders Always Wanted to Know but Were Afraid to Ask

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This weekend, Michael Cavanaugh agreed to answer those questions many traders want answered. Michael is an Independent Registered Representative with Brokersxpress, Investment Advisor representative and partner in Clinton Street Capital Inc., and former floor trader at the CBOT. As a floor trader, he worked at one of the busiest institutional execution desks in the futures/commodities industries. He holds licenses in NFA series 3 and FINRA series 7, 63 and 65. In addition, he has written daily analysis and has been recognized by quoted and published leaders in the industry.

Michael also happens to be the broker that many Option Investor and CPTI subscribers trust with their accounts. Michael notes that his location in Chicago allows him to visit each exchange numerous times a year. He speaks frequently with market makers, former and present, and understands the CBOE market maker position as well as that he held as a floor trader at the CBOT.

Question: Michael, a webinar participant once asked a former market maker whether market makers sometimes forgot orders. The person asking the question said that his broker had told him that the market maker "had probably stuffed it in his pocket and forgotten about it." In this day of hybridization and electronic orders, is that even possible?

Answer: A couple of different terms that get confused and lost in the mix are the actual names of positions for the people on the floor.
Market Maker: One who actively represents bids and offers on any securities to provide liquidity to the marketplace.
Floor Broker: One who represents customers orders and presents them to the market makers. (Although this position is becoming less and less needed, there are still floor brokers.) So in the example above it would not be the market maker, but rather the floor broker. So the next question is, Could the floor broker have the order stuffed in his pocket? It is possible. However, floor brokers get paid for each order they execute. It is within their best interest to represent customer orders as best possible, so they can make more money. A good floor broker is human and can make errors, but very few and far between. In the past 5 years there has been a push to electronic trading and with this comes the use of electronic order entry to the floor brokers. An order used to be routed to an exchange via telephone, the order written down, a runner would take the order to the executing floor broker, the broker filled the order, and the runner took it back to the trade desk for confirmation. Now that we can enter orders electronically, there is less paper trail and less probability that the order was stuffed in a floor broker's pocket.

Question: Some traders express confusion about how options prices are set. What part does the Market Maker have in setting prices and what part does supply/demand have?

Answer
: In the "old days" and currently in a very few pits (SPX, OEX) market makers represented the bids and offers on every option, spread, combo, etc. via open outcry.The extent of how they priced the options is most generally a function of the option's volatility. Market makers used to hold onto option value sheets that showed theoretical prices of options if certain aspects of the options underlying were to change, such as vega, delta, gamma, etc. These sheets have been replaced by very expensive and more accurate options-pricing software. The ability a computer has to manage the bid and ask spreads, filtering the info from the software, is so much more efficient and effective than the option sheets provided, and there are now less and less market makers around. One computer is able to do the work of many market makers. (I dont know if there is a way to quantify this, but my guess would be 1 computer = 100 market makers.) Supply and demand does come into play, as the market maker may not want to take on any more risk at a certain price, even if volatility doesnt change. This would cause a market maker to lower the bid or raise the offer.

Question: How does the market maker or specialist make money?
Answer: A market maker makes money on taking short-term risks and laying the risk off as soon as possible, and duplicates this as many thousands of times as he/she can. Futures, single stock futures, other options, and underlying stock are the vehicles used to "lay off" the risk presented in the original transaction. For instance, if someone bought 1 Call on Microsoft, the market maker may receive a .05 cent "edge" on this transaction and would immediately buy 100 shares of Microsoft to hedge the risk. The market maker then manages the inventory and remains as hedged as possible, and makes money on the multiple transactions, receiving penny increments of an edge.

Question: Some assume that the market maker relishes running stops before reversing the market. Is this true, as some retail traders presume?

Answer: I would put this in the category of "urban myth." In order for this to happen, a market maker would have to be privied to the placements of the stops. The only way this could happen is if someone were to share this information with the market maker, which is a severe rules violation and would more than likely end up with thousands of dollars in fines and suspensions to all involved. This has happened, although the only occurrence I heard of was in the soybean pit in 1988, when a market maker and a floor broker were in cahoots. Several people were handed very large fines and lifetime suspensions from the exchange. The exchanges have safeguards in place to protect the integrity of the exchanges and to prevent this sort of manipulation from occurring. Each exchange has its version of internal affairs and investigators that investigate suspicious activity. The investigations are swift and painful if you are doing something unethical. Upon receiving a membership, floor brokers and market makers are required to take hours of ethics training to ensure they understand the ethics of business in the marketplace, and it is made clear that there is no gray area. It is black and white when it comes to ethics.

Furthermore, most online retail brokerages do not place stops in the marketplace. The stops are held in the brokerage firms queue until the trigger price is elected. Once elected the stop is sent to the exchange. So there is no way to know what and where the stops are until elected. Hypothetically, market makers who have a keen sense of technical analysis could logically guess where stops from retail traders are placed and attempt to "run stops" where they think they would be. They would be stepping out of their traditional role as liquidity provider and into speculator at this point, and the statistics of market makers show that the ones who speculate are not around as long as the ones who are there to do the job of a market maker, in providing liquidity and profiting from the quick edges they receive for making the markets.

Question: Most market makers seem much more concerned about neutralizing risk than the average retail trader. Is a market maker most concerned about delta and gamma (price movement), theta (time decay), vega (volatility risk) or even rho (interest rate changes), which might assume special importance in the time near FOMC decisions?

Answer: A market maker takes into consideration all the Greek aspects of an options price. The primary being vega, the measure of the option's volatility. The volatility of the option is what market makers use most to decide the price points of the trades they take the other side of. Market makers use volatility skew charts to influence their decisions. They buy low and sell high in terms of volatility. An interest rate decision would affect a market maker's inventory, as a change in interest would affect the cost of carry and may influence the decision of a market maker to hold an inventory or liquidate portions that are negatively affected by a rate decision.

Question: Does the primary concern change according to market conditions, or does the market maker try to neutralize as many of these risks as possible in one setup?

Answer: A market maker looks to hedge risk and take in the small increments of "edge" as soon as possible. They tend to not want to speculate in any situation. The decisions a market maker makes are most influenced by the volatility aspect of an options price, and determines how and how often the market maker takes the other side of the trade.

Question: What would the market maker like the retail trader to know?

Answer: I think the market maker would like the retail trader to know that they are not there to screw anyone. They go to work to perform the task of providing liquidity to the marketplace that allows us, the retail trader, to make the speculative trades that we make. They take the short term risk to allow you to be in the position you desire.
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Thanks, Michael, for the answers to some of the questions traders want to know. Our subscribers can contact Michael at Contact Support (e-mail) or his toll-free number at 866.903.1822.
 

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