Managing a portfolio of options involves microstructural modeling and pricing. Market makers must also offer a significant amount of liquidity, across a wide variety of products and tenors. This is especially true of short-dated options, which cannot be aggregated into an inventory. Nevertheless, the options market is undergoing a technological arms race. Some exchanges have incorporated auctions to help improve price and liquidity. Some have also introduced new tools to reduce market maker execution and clearing fees.
One of the largest challenges facing option market makers is the fact that options are complex and require an advanced understanding of the market. The market’s complexity may make it difficult to serve as a liquidity provider. However, the complexity can also be an asset. With the right technological tools, market makers can enhance liquidity and depth while also enhancing competitiveness. The SEC recently approved an options market making program for eligible market makers. The program will provide a pool of money each month to be divided among qualified market makers based on performance.
A market maker has the task of managing thousands of positions and balancing the risk between short-dated and long-dated options. Moreover, the market maker must provide liquidity for a wide range of expiration dates, tenors and strikes. The market maker is also required to use the correct model to determine volatility. This model is a factorial stochastic volatility model on the underlying asset. Market makers also have to meet a variety of other obligations.
The most basic of these obligations is to provide a valid quote at the opening of a trading session. Additionally, a market maker is required to meet legal quote width requirements and post liquidity in a wide range of instruments. The market maker must also honor orders routed to it from away markets. There are other privileges available to market makers, such as enhanced messaging throughput capabilities and bulk quote messages. The market maker may also participate in as much as 40% of a given options trade.
The market maker may also participate in a Public Customer-to-Public Customer Cross Order, which is a type of order in which an options trader trades the same contract for another party. However, the public customer-to-public customer cross order is subject to the same rules and regulations as other types of public cross orders. Market makers may also sell stocks short to help support their market making activities.
The market maker’s most important duty is to provide liquidity in a diverse range of products. This includes a significant number of expiration dates, strikes and tenors. The market maker has to ensure that they are providing liquidity in the smallest possible bid-ask spread. This small bid-ask spread can be highly profitable if it’s combined with high trading volume.
The SEC’s options market making program is a good example of the government’s commitment to making the market more efficient. While the SEC has a good track record of regulating financial markets, the options market has become so complicated that some market makers may be driven out of business. This program provides an incentive for market makers to be competitive in the options market.
