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Delta-neutral option quoting, explained:
Options market makers in finance are exposed to lots of risks. One risk is that prices they quote become outdated due to new info.
Delta-neutral quoting is a neat trick traders use to prevent themselves from getting picked off!
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Options market makers in finance are exposed to lots of risks. One risk is that prices they quote become outdated due to new info.
Delta-neutral quoting is a neat trick traders use to prevent themselves from getting picked off!
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When options market makers quote a price to clients, clients have a few mins to choose whether to take the trade or not.
While waiting, the market maker is vulnerable. If the market moves fast, their old quoted price could become very unprofitable for them.
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While waiting, the market maker is vulnerable. If the market moves fast, their old quoted price could become very unprofitable for them.
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For example:
If a market maker is selling 100 Tesla call options to a client, the MM fears that Tesla will spike upwards in price.
In that case, the market maker's old quoted price allows the client to buy the calls for way too cheap, causing the MM to lose a lot of money!
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If a market maker is selling 100 Tesla call options to a client, the MM fears that Tesla will spike upwards in price.
In that case, the market maker's old quoted price allows the client to buy the calls for way too cheap, causing the MM to lose a lot of money!
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How do market makers protect themselves here?
The solution:
They reduce their risk by requiring the client to also conduct a parallel (and opposite) trade in Tesla stock if they want to trade Tesla options!
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The solution:
They reduce their risk by requiring the client to also conduct a parallel (and opposite) trade in Tesla stock if they want to trade Tesla options!
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In the example above, the market maker would lose money if Tesla goes up.
To neutralize this risk, the MM requires the client to make another trade that would MAKE the MM money if Tesla goes up.
That parallel trade? The MM just buys Tesla shares directly from the client!
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To neutralize this risk, the MM requires the client to make another trade that would MAKE the MM money if Tesla goes up.
That parallel trade? The MM just buys Tesla shares directly from the client!
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If the client wants to buy 100 Tesla calls, the MM will quote a price. But, the client can only execute that trade if the client lets the MM buy Tesla at the same price
The option's delta determines how much Tesla the MM buys. At a +1 delta, the MM buys 100 shares of Tesla.
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The option's delta determines how much Tesla the MM buys. At a +1 delta, the MM buys 100 shares of Tesla.
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If Tesla goes up by $10, the MM would have lost $1000 ($10 per call) from the options trade
But, the client would also have to sell 100 Tesla shares in order to buy the calls.
The spot trade is now 100 * $10= $1000 more profitable now for the MM, so the MM is safe from arb!
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But, the client would also have to sell 100 Tesla shares in order to buy the calls.
The spot trade is now 100 * $10= $1000 more profitable now for the MM, so the MM is safe from arb!
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But what if the client didn't want to trade Tesla stock, just calls?
No big deal - the client can just go buy Tesla stock right before the trade, and then immediately sell it to the market maker, never taking any risk from the spot trade!
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No big deal - the client can just go buy Tesla stock right before the trade, and then immediately sell it to the market maker, never taking any risk from the spot trade!
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This strategy is effective in practice and is widely used by MMs to reduce risk when quoting.
On trading floors, you'll often hear options traders asking to also "trade the delta" when trading options.
That means they want to make a delta-neutral trade from the start! :D
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On trading floors, you'll often hear options traders asking to also "trade the delta" when trading options.
That means they want to make a delta-neutral trade from the start! :D
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