Chris Capre, head professor of Benzinga Options school, discussed how option dealers and market makers hedge on a daily basis at the Fintwit Conference presented by Benzinga and Lupton Capital.
Changing Option Market: Capre said the options market is undergoing a massive change. In fact, options volume is now surpassing share volume in the market, he said.
"You have to understand how options are moving the market, particularly how option dealers and market makers are pushing the market," he said.
Related Link: How To Read And Trade An Options Alert
Market makers in the options market make money by filling orders, and they collect the spread regardless of whether the market is going up or down. Capre said at least 50% of daily option trading activity comes from dealers and market makers.
"If you come in and say hey, I want to buy SPYs, I want to buy 100 calls at the 400 strike, the option dealer/market maker is on the other side of that transaction. You buy 100 calls, they're short 100 calls," Capre said.
Market Maker Hedging: The market maker does not want to make money based on the direction of the market because there's too much risk involved, he said.
"They want to collect that transaction fee because they can do it a million times a day, and so they are going to immediately delta hedge that position, immediately algorithmically, done instantly," he said.
The four things these market makers hedge on a daily basis are delta, gamma, implied volatility and time.
"At certain points in price, the dealers are forced to hedge either by buying more shares or selling more shares," he said.
A market maker that has a net long options position has positive gamma.
"If dealers are buying shares, they're adding liquidity to the market, right? And generally markets don't crash when liquidity is strong. Markets generally crash when liquidity is weak," Capre said.
Market maker hedging volume can either contribute to the market's trend or can go against the trend, causing mean reversion.
"If you can understand how the dealers and market makers are responding to the overall position, you can start to speculate ahead of time," Capre said.
"Based upon this, this is going to mean revert, dealers are going to trade against this, or based upon this, dealers are going to trade with this. This is going to exacerbate the move to that side," Capre said.
Learn more about this and other upcoming Benzinga events at this link.
