Dawn Pennington

Make or Break Options Trades

    Tweet This

Generally speaking, there is a counter-party to every trade, which means that for every trader who wishes to sell, there is a buyer. If you trade through a broker or bank -- which even includes exchanging cash for traveling -- then the broker or bank acts as the market-maker. Said another way, they trade with you and then trade on a major exchange.

Market-makers affect options in a wholly different manner. Originally, on stock and commodity exchanges, the market-maker for the underlying security would also make a market in calls and puts. The majority of options trades these days, however, are made between a market-maker and the buyer or seller. That is, as an options trader, you are working directly with the market-maker, not a removed counter-party.

Options market-makers try to balance trades by using spreads, by dealing with other market-makers personally, or by staying "delta neutral" (that is, keeping extra stock in their accounts or shorting stock to cancel the consequences of their being naked short the calls and puts they sell to the general market).

The market-maker's impact on options can be quite significant, often sending options premiums skyrocketing in a matter of minutes. When the price of a stock fluctuates wildly, the market-makers widen the spread on the options so that they cut the risk of a major fund swooping in to capture profits for the day.

The lesson for options traders is that you must realize that every trade you make is with a savvy professional market-maker, one who is going to hedge their bets. You are not trading with another retail investor or with an institutional investor; you are trading with a firm that uses zero-risk strategies to lock in a profit.

It can be challenging to understand how options differ from other investment vehicles, but the big profits that options can bring -- with far less capital -- can make the little time required to understand the intricacies much easier to bear.