Dealers, also known as market makers, are financial entities responsible for providing liquidity in financial markets by facilitating the buying and selling of securities. Dealers play a crucial role in ensuring smooth and efficient trading, as they help maintain orderly markets and narrow bid-ask spreads.
Trade and Maintain a Two-Sided Market
During the trading session, dealers are required to maintain a two-sided market on each option series under their responsibility. Dealers take the other side of a relatively high percentage of option trades. However, trades can and do take place without the dealers' involvement. This happens when a bid and offer fall between the dealers' bids and offers, or when a large market order takes out participants' bids and offers.
The way dealers set bid-and-offer prices is usually influenced by two factors:
• First, dealers must keep prices relatively close to the option’s fair value. To do so, they use option-pricing software that constantly updates the fair value of an option. These software tools typically use some variation of the Black-Scholes model or the binomial model.
• Second, dealers will adjust their bids and offers depending on their current positions. For example, if they find themselves taking the other side of multiple buy orders (i.e., if they are selling many options), they will increase their bid-and-offer prices to attract more sellers to the market. When sellers come into the market, it has a balancing effect on the dealers' position and lowers their overall risk.
Maintaining a Two-Sided Market
Suppose a participant is neutral to slightly bearish on the SPX. The participant would like to sell 10 SPX June 21 5400 calls at no less than $22.50. The participant enters the limit order with their broker. The system automatically enters the order into the exchange system, which time-stamps it for priority. If the best bid for SPX June 21 5400 calls is $22.50 or more for at least 10 contracts, and the best bid has been posted by the dealer, the participant's order will be filled (at $22.50 or better). The participant and the dealer are then notified of the fill. The dealer now owns 10 SPX June 21 5400 call options, not because they are bullish on SPX, but because of their responsibility to maintain a two-sided market within a maximum spread quotation acceptable by the exchange. The first thing the dealer must do now is enter another order to buy SPX June 21 5400 calls, thus maintaining the two-sided market. If the dealer happens to be bullish on SPX and if they have risk capital available, they may leave all or part of the position unhedged. In most cases, however, the dealer will try to reduce or eliminate the total exposure.
How Dealers Hedge Their Options Risk Exposure
Dealers can reduce or eliminate risk in their options book in any of the following ways:
• Adjust the bid-offer spread
• Hedge their option positions by buying or selling the underlying stock/futures.
There are other, less common ways in which a dealer may hedge their exposure; these can include establishing option time spreads or straddles/combinations, as well as establishing conversions and reverse conversions.
Adjusting the Bid-Offer Spread
One way the dealer in our example may reduce exposure to the 10 SPX June 21 5400 calls is by lowering his bid-and-offer prices, potentially enticing a participant to buy the option series. If the dealer can offset the position by adjusting the bid-and-ask prices, his exposure to the price of SPX is neutralized (assuming that the dealer has no other positions in any SPX options). If the bid-and-offer prices fail to attract any orders to the market, the dealer will usually hedge, either completely or partially.
Hedging by Buying and Selling the Underlying Stock
The most common hedging method is called delta hedging. Delta represents the amount an option's value is expected to change given a dollar change in the price of the underlying. Dealers are constantly aware of a particular option's delta because it informs them how many underlying shares/futures they must buy or short to hedge the option position.
Carrying on with our example, assume that SPX is trading at a price of $5400, and that the delta on the June 21 5400 call is 0.50.
A delta of 0.50 indicates that, if the price of SPX increases by $1, the value of the option is expected to increase by 50 cents (+$1 × 0.50). Similarly, a $1 decrease in the price of SPX is expected to lower the value of the option by 50 cents (–$1 × 0.50). Because the option premium has less than a one-to-one relationship with the stock price, fewer than 100 shares of stock are needed to hedge one option contract. In fact, a delta of 0.50 means that only 50 shares (100 × 0.50) are needed to hedge each option contract, and therefore 500 shares are needed to hedge 10 contracts.
But should the dealer buy or sell 500 shares? In this case, the dealer's position delta is +500. To delta hedge this position, the dealer must establish a delta position that has a delta relative to the price of SPX of –500 (so that +500 + (–500) = 0).
The easiest way to delta hedge is by selling short 500 shares, although dealers often hedge via futures. (which becomes slightly more complex). If the dealer sold 500 shares short against the long position in 10 option contracts, and if SPX fell by $1, the value of the option premium would fall by $500 ($0.50 × 100 × 10 contracts). The $500 decline in the value of the option would be offset by a $500 gain in the value of the short 500-share position.
However, if the delta fell to 0.40 from 0.50, the dealer would need to be short only 400 shares and would therefore buy back 100 shares.
Key Takeaways
The key takeaway is that dealers are constantly trading stocks/futures to sustain delta neutrality in their options book, significantly impacting the underlying movement, especially as the SPX approaches large options expirations like monthly and quarterly OPEX. Utilizing the gamma charts helps identify the dealer's position, whether it's long gamma (positive gamma) or short gamma (negative gamma), and pinpoints areas where substantial buying and selling activity will occur.