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I’m stuck between two fields of thought, and I’m curious if anyone knows how this works in practice?

On one hand, if the MMS have a bid and ask based on current supply and demand and nothing changes, then I’m not sure why they would change their prices? That is, the bid and ask quote will only change after MMs receive orders and/or orders fill on the exchange. If they are accumulating limit orders that aren’t filling, will they adjust their bid ask, along with as trades fill?

On the other hand, would they continually adjust their bid ask regardless of receiving orders in order to continually quote to try and provide liquidity and constantly adjust to avoid stalemate in the market?

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Short answer: Mostly, yes.

Long answer: Orders will be updated frequently based on new information. How frequently depends on how frequently new information is arriving. Any new information to the market may be used to assist in adjusting outstanding orders. New information has numerous forms, some directly related and some only indirectly:

  • A trade in the specific security
  • A trade in a directly related security (stocks for options, options for the stock, or maybe even a big trade in convertibles or other debt of the company)
  • A trade in another correlated security (maybe the S&P index starts falling sharply then prices of this stock should probably be lower too depending on the company)
  • A new order in the security (maybe there's suddenly a big sell order above the last trade)
  • News pertaining to the security/company or the market more generally
  • The trader's wife calling him to say their kid got into a fight at school so the trader pulls most of his orders to have a chat with his wife.
  • etc, etc, etc.
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The market maker controls the bid and ask price only if the security is illiquid and there are no orders on the order book within the MM's bid/ask range. Any trader who places an order at a better price becomes the market until someone else supersedes him

For example, the NBBO quote is $24.70 x $25.00 and the MM is on both sides. If I place a buy order at $24.71 then I become the bid and the MM remains the ask with the quote then becoming $24.71 x $25.00. This new quote will remain until either someone takes out either side or an order comes in at a better bid or better ask price.

Options are the same as above (the auction determines the quote) except that in addition, if the MM is on both sides, his computerized program will adjust the option price as the price of the underlying changes. If this did not occur, there would be price dislocation and free money.

For example, XYZ is $52 and the soon to expire in-the-money $50 call is $1.90 x $2.10 (the intrinsic value is $2.00). XYZ rises to $53 and the $50 call's intrinsic value is now $3.00. In the absence of other market participants, why would the MM leave a stale ask price quote of $2.10, allowing you to buy a call worth $3 for only $2.10? That would be free money. Prices adjust automatically.

There is a small amount of price dislocation with options when the B/A spread is wide and/or the delta is lower. The option's price isn't going to change penny by penny as the underlying changes penny by penny unless the underlying and its options are heavily traded (for example, the SPY).

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