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.
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
Question: How does the market maker or specialist make money?
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.