Options traders who have progressed beyond the basics would do well to read Dan Passarelli’s The Market Taker’s Edge: Insider Strategies from the Options Trading Floor (McGraw-Hill, 2011). Passarelli, a former market maker, shares a few war stories and explains how the stay-at-home trader (the potential “market taker”) can profit from learning what market makers actually do.
The author highlights one difference between “them” and “us” with a story about interviewing applicants for a job to work as an options instructor. All of the applicants had to be current or former professional traders. “Upon arrival at the job interview, traders were given a test that included a few questions that required them to draw at-expiration diagrams for various options strategies. Unexpectedly, more than a fair share of market makers couldn’t complete that part of the test! … Why couldn’t many of the market makers draw these simple diagrams? They are not in the habit of doing so: they don’t need to do so.” (p. 26) They rarely have to deal with absolute, maximum risk since they don’t hold trades until expiration. By contrast, expiration graphs are drummed into the heads of retail traders, and it is only later that they learn that those gorgeous iron condor expiration graphs are a lot less impressive earlier in the trade.
Passarelli spends time on topics most options books ignore, such as order entry (including middling the market), the usefulness (and most often uselessness) of stops on spreads, gamma scalping, synthetics, and position risk thresholds.
Here are a couple of takeaways.
Market makers try to avoid delta bets because “delta is generally a much bigger risk than the risks associated with volatility.” And volatility is, according to academic studies, more predictable than directional price movement. Passarelli continues: “Market makers hedge option trades to eliminate the haphazard directional risk in favor of being left with only the two volatility risks of vega (implied volatility) and gamma/theta (realized volatility). In fact, market makers would generally prefer to also eliminate volatility risk in favor of the arbitrage-like scenario of buying bids and selling offers and going home flat each night. However, positions usually cannot be completely eliminated because each individual option is not liquid enough to day trade and end each day with no position in any series. Thus options must be spread to reduce the impact of vega, gamma, and theta.” (p. 161)
The philosophies of market makers and market takers are radically different. “Market takers make a living selling options (or option positions) at a higher option premium than that at which they buy. Market makers make a living by selling at a higher volatility than that at which they buy. Though … they may be trading the opposite sides of the exact same options, their differing trading perspective makes for a symbiotic relationship.” (p. 210)
To end this review on a lighter note, as Passarelli ends his book, what did pit traders do doing the down times on the trading floor? There was a lot of competition, from how long you could hold your breath to how many eggs you could eat. Passarelli elaborates: “In the pit in which I traded, we would do brain teasers, ask each other what a certain number was in another base—for example, ‘What’s 32 in base 7?’ Game theory questions and obscure trivia always passed the time as well. For a while, we had a Scrabble board set up. You really learn to play Scrabble strategically when you’re playing against traders. And, always, when the Price Is Right came on, we changed the channel to watch.” (p. 222)