Market-making

In financial markets, natural buyers and sellers may enter the market at different times and for different
quantities, so they face a risk that they can’t do their transaction immediately. To facilitate them,
professional traders stepped in by continuously providing a bid price (a price at which they willing to buy so
that others can sell) and an ask price (a price at which they willing to sell so that others can buy) for
financial instruments, and therewith provide a so-called two-sided market in those instruments. This
ensures liquidity in the market and execution certainty for investors. This type of trading is called liquidity
providing or making markets. And these professional traders are therefore called liquidity providers or
market-makers.

Before reading further, take a moment to think about following questions: what is the risk of a market-
maker? How do you think a market-maker can be profitable?

Market-makers earn money by generating very tiny profits on a large number of trades. On one hand, they
aim to provide the best bid price and best ask price as possible (beating their competitors) to ensure that
they will do many trades. On the other hand, by improving the bid price and ask price, the difference
between both (the bid-ask spread) is decreasing, which lowers their profit expectation. A market-makers’
success depends on it being among the first to post the best available prices.

Furthermore speed is important from a risk management perspective: whenever a market-maker provides
a two-sided market (or simply quote) in a financial instrument, they are exposed to the risk that the market
moves against them. Market-makers quickly and continuously update their quotes to reflect the new
market situation, which enables them, to show quote a narrow spread. The use of sophisticated and fast
trading applications is a prerequisite for a market-maker to be successful.
Market-makers usually take no intentional directional positions in securities. They aim not to have any
positions longer than a few hours; also they try to end the day with a very small (flat) position.

An Example
Making a market in BHP, we provide both a price we are willing to buy and a price we are willing to sell.
Let’s say BHP is trading @ $35 and we want to make a 4c market (which means we want to have a bid-ask
spread of 4c), then this would look like this:

34.98 @ 35.02
This notation means we are willing to buy BHP at (@) 34.98 and willing to sell at 35.02. If we buy 1000
shares @ 34.98 we make money as the stock goes up. So if BHPs share price rises to $36 we have a
theoretical profit of, 1000 * (36 – 34.98), $1020.

If we had sold BHP @ 35.02 and the stock rose to $36 we would have a theoretical loss of, -1000 * (36 –
35.02), $980.

If we bought 1000 BHP shares @ 34.98 then sold 1000 BHP shares @ 35.02 we would have made, 0.04 *
1000, $40.

From the example you can see that you are able to sell the instrument without owning it first. This is
known as short selling. If you buy bread in the supermarket, settlement is immediately: you pay and take
the bread home. In Financial markets, the transactions are generally settled two days later. Because you
don’t have to settle immediately as a seller, you can first sell the stock (short sell) and buy it back later that
same day.

When you short sell you make money by the instrument falling in value. Back to the example above, if we
had sold 1000 BHP shares @ 35.02 and the share price fell to $34 then we would have a theoretical profit
of, 1000 * (35.02 – 34), $1020.

Options Basics
One of the main product categories that Optiver trades in is options. There are two main types of options;
call options and put options. Options are derivatives, meaning that their value is derived from another
product. The broad definition of an option is as follows:

“In finance, an option is a contract which gives the buyer (the owner) the right, but not the obligation, to
buy or sell an underlying asset or instrument at a specified strike price on or before a specified date.”

When the owner of the option decides that they want to take up their right to buy (call option) or sell (put
option) the underlying (stock, future etc.), it is referred to as exercising the option. For our purposes, you
would only exercise the option if the option gives you the chance to buy or sell the underlying at a better
level than is currently available in the market.
Example:
BHP shares are trading at $68. There is a BHP call option with a strike price of $80. As a call is the right to
buy the stock at the strike price, there is no reason that the owner of the call would exercise the option
unless the stock price went over $80 as he/she could just buy it at the lower price in the market if it was
below $80. If the stock price does get over $80, then you would refer to this option as in-the-money. On
the day that the option expires the option will be worth either 0 if the stock price is below $80, or it will be
the difference between the stock price and the strike price:

Value of Options at Expiration = 0 if Stock < 80, or

So how much is this call worth now with the stock price at $68?

This will depend on a number of factors. How long until this option expires? If the option expires in 5 years
there is a much greater chance that the stock price ending up over $80 than if it expires tomorrow. How
much does the BHP share price move (volatility)? If the stock goes up and down $10 per day then there’s
more chance of the option ending up in-the-money than if it only moves 1c per day.

The way to derive the price of an option can be made clearer when you look at something more discrete.
Let’s consider pricing call option with a strike price of 4 on one roll of a dice.
As it should have been clear from above, the only time that this option would be exercised would be if the
dice came up with a value greater than 4.

Possible outcomes Probability of Outcome Call Option Value