Who's on the other side of very illiquid option contract trades?

Question

So I've been short selling Deep-in-the-Money, far from expiration Put Options on an ETF for about a year now, to profit from upward price movements on the underlying and time premium decay.

Volume for these contracts has been 0 this entire time, and Open Interest only shows my active positions. In other words, these contracts are extremely illiquid and it looks like I'm the only one trading them.

However, when I sell and buy the contracts, the orders are filled immediately and at a pretty fair price somewhere in the middle of the bid-ask spread.

So, my question is, who's buying my contracts on the other side of my order? Is it just a market maker? If so, why? Is it purely a legal requirement that comes with the job of being a market maker? Time decay and the underlying's price tendency to rise, translates into a bias for the contract to be worth less over time; is the market maker on the hook for these losses? The bid-ask spread is pretty wide to justify this risk for them, but since I'm getting fill prices somewhere in the middle of the bid-ask spread when I buy and sell, does the spread even matter?

Answer 1

The market maker has the responsibility of making a market in the security. That means that he must provide a quote that is subject to maximum width limitations as well as be willing to trade a minimum required volume at that price. He is under no obligation to fill your order at a better price. The fact that you are getting a fill at the midpoint means that he or another trader finds that price attractive and is willing to take the other side of the trade.

Market makers hedge their exposure by being delta neutral. If the put that buys from you has a -90 delta, he could buy and/or sell any number of other options and/or stock that provide +90 delta, moderating his risk.

The ideal scenario (less likely to be applicable here) would be where there is a put seller (you) and a call buyer (Trader B) for the same series and the market maker executes a conversion. He buys the stock, sells the put to you and sells the call to Trader B, locking in a risk-free gain. You and Trader B shoulder all of the risk.

If your midpoint offers are being filled immediately, you might consider placing a more aggressive order at a better price to see what the limit of their generosity is. If you don't get a fill, incrementally move your price toward the midpoint.