Who's Selling You That Options Contract?!

Uncovering the Hidden World of Market Makers [Image] Who's Selling You That Options Contract?! Uncovering the Hidden World of Market Makers When you buy an options contract, do you know who is selling it to you? The answer lies behind the curtain of the options market, where big, shadowy money quietly keeps the market moving. I’m talking about market makers — individuals (or entities) who professionally buy and sell options contracts, looking to profit off of the bid-ask spread. WARNING: You might be buying options without the slightest clue about who is on the other side of the trade! There’s a lot of confusion about who market makers are, what they do, and why options traders should pay close attention to their moves. But, make no mistake — if you don’t understand these concepts, the market makers will eventually move your money from your account to theirs. Let’s prevent that from happening. Keep reading and I’ll tell you everything you need to know about market makers… What Market Makers Do In the financial world, market makers are like helpful coordinators in a huge, complex marketplace. They provide liquidity, ensuring that trades can happen smoothly and continuously. They also quote prices to buyers and sellers. Imagine you want to sell your old laptop, but you're not sure how much to charge. The market maker will tell you, "I'll buy your laptop for $200 each" (the bid) then, tell another person, "I'll sell you this laptop for $210 " (the ask). The difference between these prices ($210 - $200 = $10) is called the spread, and it's how market makers make their money. Market makers are typically big financial institutions or firms, trading in massive size and volume. They don’t care about individual trades. It’s all about volume. The more you trade, the more they make. Now, let me draw an analogy… If options traders are the casino gamblers of the stock market, then market makers are the house. They give us a table to play our game on by taking the other side of our speculative bets. I’m sure we’ve all heard the saying: “The house always wins.” But with the perfect circumstances and a bit of luck, gamblers can potentially bankrupt an entire casino. Remember when r/WallStreetBets nearly shuttered the hedge fund Melvin Capital? (More on that later…) In this analogy, trading isn’t roulette or blackjack — it’s poker. It’s primarily a game of skill where chance plays a role — not the other way around. Just as excellent poker players study constantly when they’re away from the table, competent traders do the same when they’re not actively trading. For options traders specifically, a key part of this study should be developing a firm grasp of the role of market makers. In particular, there’s one facet of market-making that you can potentially weaponize to your advantage… Why Market Makers Matter This is the part where it gets really interesting for traders… You see, market makers often hedge to protect themselves from adverse price movements. When they take the opposite side of an options trade, they may buy or sell the underlying stock to maintain a ‘delta neutral’ position. For example, if a trader buys a call option (betting the price will rise), the market maker might buy the underlying stock to hedge against that bet. Then, buying begets more buying, because market makers have no choice but to keep their positions neutral. Most market makers run their businesses conservatively and never take on outsized risk. But occasionally, others make judgment errors and miscalculate their ‘neutral’ position in the market. This is exactly what happened during the GME short squeeze. When options get squeezed, it’s called a ‘gamma squeeze.’ And because each options contract represents 100 shares of the underlying stock, it’s like a short squeeze on steroids. Gamma measures how much an option's delta changes for each $1 movement in the underlying asset. Delta, in turn, measures how much an option’s price will change with a $1 movement in the underlying asset. Why should you care about this? Because when market makers adjust their hedges (due to their gamma exposure), it can cause HUGE price shifts in the underlying stock. This is especially relevant for options traders — you must be mindful of gamma risk as expiration approaches, as it can amplify price movements impact your profitability. Many traders watched GME blast off and thought it was all about a traditional short squeeze, but they missed a vital piece of the puzzle — the role of market makers. GME never would’ve hit the highs that it did in a traditional common-share short squeeze (without market makers and options contracts). Closing Thoughts It's not straightforward to predict how and when market makers will hedge their positions. However, by understanding these dynamics, you’ll have an easier time navigating through the short-term price movements of the options market… Now, you’ll be able to adjust your strategies and risk-management tactics to account for — and potentially take advantage of — the added volatility introduced by market makers’ hedging activities. As always… Stay Street Smart, Jeff Zananiri P.S. My overnight trade idea has already been delivered to Burn Notice Members, but the next one could be even bigger! 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