How Market Makers Hedge Their Risk

[Trading With Larry Benedict]( How Market Makers Hedge Their Risk By Larry Benedict, editor, Trading With Larry Benedict One way to better understand options is by viewing them through the eyes of an option market maker. We did that [a month ago]( We discussed how exchanges employ market makers to, as their name implies, “make a market.” They provide liquidity by quoting bid and offer prices on a range of call and put options. That way, traders can readily enter and exit positions. One of the key themes we looked at then was the impact volatility has on market makers’ risk. That also affects the price they charge for option premiums. Today, I want to delve into how market makers hedge that risk. That can help you understand options more fully – and become a better trader… Recommended Link [America’s ‘Silent Invasion’ Is YOUR Town in the Crosshairs?]( [image]( Time is short to prepare. [Click the map to find out what happens next.]( -- Taking on Obligations Let’s begin where most folks do when they’re getting started with options – buying a call option… When you buy a call option, you’re betting that the value of the underlying asset will rise. If the stock price rises before the option expires, you can generate a tidy profit. By buying the call option, you gain a right. You can buy shares at the option’s strike price by exercising the option before it expires. The key point here is that it’s your choice. By paying the premium to the market maker, you get to choose what to do. What if the share price trades sideways or falls and your call option expires worthless? Then the market maker gets to keep the premium. Doing this multiple times over numerous stocks is how they make their money. By receiving that premium, however, the market maker takes on an obligation. If the call option buyer decides to exercise their option, the market maker must hand over the shares at the option’s strike price. If they sell a call option with a $100 strike price, they must hand over the shares at that price. That’s the case even if the stock skyrockets to $200, $300, or much higher… You can see that it would only take one massive rally to put the market maker out of the game. We saw a rally like that happen with Nvidia (NVDA) in the AI boom. So the market maker might also take out the opposite position to protect themselves. Free Trading Resources Have you checked out Larry’s free trading resources on his website? It contains a full trading glossary to help kickstart your trading career – at zero cost to you. Just [click here]( to check it out. Hedging the Bets Let’s stick with our NVDA example… especially given that earnings are due out on Wednesday. NVDA is trading around $130. So let’s say I decide to buy a call option with a $130 strike price. (Please note that this is not a trade recommendation.) If NVDA’s earnings surprise to the upside, the stock could surge upward. Then I can exercise the option and pay $130 per share for 100 shares of NVDA. If the stock is trading at $140, for example, I can immediately turn around and sell my new shares for a profit. But what if I’m wrong and earnings disappoint, sending the stock sharply lower? Then the most I can lose is the premium I paid for the call option. But consider the market maker. They must be able to hedge their position to cover any risks… especially if NVDA gaps higher. One way the market makers can protect themselves is by buying NVDA shares at the same time. That way, they’re covered no matter how high the NVDA price goes… and can fulfill their obligations if a buyer exercises their options contract. But something is missing… Adding Another Leg If the NVDA stock price tanks, the market maker is going to lose money on their shares. Theoretically, those shares could go all the way to zero. That’s why the market maker needs to add another leg to their position – a bought put option. Remember, a put option gives the buyer the right to sell shares for the strike price. So the market maker sold a call option at $130 and bought 100 NVDA shares at $130. Then they also need to buy a $130 put option to complete their hedging strategy. Even if NVDA falls, they can exercise their put option to sell their shares for $130 per share. That way, they’re covered whatever the share price does. This is just one way market makers hedge their positions, of course. But it’s important to understand how this relationship works. By following the dynamics of the options market, you gain a better understanding of how the different pieces fit together. And that helps you become a better options trader. Happy Trading, Larry Benedict Editor, Trading With Larry Benedict [The Opportunistic Trader]( The Opportunistic Trader 55 NE 5th Avenue, Delray Beach, FL 33483 [www.opportunistictrader.com]( To ensure our emails continue reaching your inbox, please [add our email address]( to your address book. This editorial email containing advertisements was sent to {EMAIL} because you subscribed to this service. To stop receiving these emails, click [here](. The Opportunistic Trader welcomes your feedback and questions. But please note: The law prohibits us from giving personalized advice. To contact Customer Service, call toll free Domestic/International: 1-888-208-6550, Mon–Fri, 9am–5pm ET, or email us [here](mailto:feedback@opportunistictrader.com). © 2024 Omnia Research, LLC. All rights reserved. Any reproduction, copying, or redistribution of our content, in whole or in part, is prohibited without written permission from Omnia Research, LLC. [Privacy Policy]( | [Terms of Use](