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  1. Assume PhD researchers at Market Maker like BNP Paribas or Deutsche Bank CORRECTLY concludes the following stock and option are stupid and unreasonable, they will lose money buying them, and do everything to avoid buying them. MM hates to buy

  2. penny stock that has scant volume.

  3. very Out The Money option that has scant volume and open interest.

Then someone places orders to sell 2 and 3, but nobody's offering to buy 2 and 3.

  1. Must MM offer to buy 2 and 3?

We assumed MM is correct. Assume penny stock in 2 went to 0, and option in 3 never hits Strike Price.

  1. Won't the MM lose money on 2 and 3?

  2. In general, if MM must buy or sell securities that it fore-knows will lose money, won't the MM lose lots of money?

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A. Options Market makers are only obliged to quote (post two-sided quotes) 60% of the time, and then only $5 wide (with exceptions).

B. Furthermore, exchanges will generally only list options for securities where there is interest from a market maker.

  1. penny stock that has scant volume

It is unlikely an exchange would list options in a penny stock, nor would a market maker be willing to make markets in such a stock.

  1. very Out The Money option that has scant volume and open interest

This is common, for example the day after expiration, new options are listed in new series for new expiration months - the market maker will post quotes with no open interest and no volume. The market maker will calculate what the options are worth, add their desired spread (as long as it is equal to or less than $5 wide) and post their quotes.

  1. Must MM offer to buy 2 and 3?

If they are appointed as a Designated or Primary Market maker in that class by the exchange, then they would likely have to quote 99% of the series or 99% of the time, so most likely they would quote that series. However if they were only a Competitive Market Maker, they would only likely have to quote 60% of the time, so maybe not. However market choose which names they wish to be appointed, so may not choose to be appointed in a penny stock, and they can drop or sign up to new appointments from one day to the next.

  1. Won't the MM lose money on 2 and 3?

They decide the price and the spread. The spreads are also further adjusted by the spreads of the underlying security, for example if the underlying is $10 wide, the market maker might widen their $5 wide quotes by another $10. But if there is insufficient volume for them to delta hedge then they would likely drop the appointment or not quote and pay the fine.

  1. In general, if MM must buy or sell securities that it fore-knows will lose money, won't the MM lose lots of money?

The spreads allow them to cover any potential losses, and they can resign appointments. Ultimately, market makers who can't make a profit go out of business.

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Why would a market maker hate buying a very OTM option that has scant volume and little to no open interest? When there are no other orders, the market maker posts a wide spread, making the you, the option seller sell for less than fair value. So OK, this is a high probability likely win for you for a gain of pennies. The market maker doesn't operate in vacuum, worried about winning or losing on one trade. He maintains his book by laying off risk via arbs like conversions and reversals and by delta neutral hedging.

Consider a simplified conversion at current price as an example of laying off the risk (it ignores carry cost and dividends, if any). Suppose I want to sell the XYZ May $50 put and you want to buy the XYZ May $50 call. The market maker takes the other side of each of these trades and also buys the stock. His position is a conversion:

+100 XYZ

+1 May $50 put

-1 May $50 call

If you do the math, he has no risk (ignoring pin risk). If both of us traded at the market, we paid the spread (the MM's gain). If one of the two options was mispriced, the MM has additional gain. The MM couldn't care less what the underlying's price does. He has garnered the two spreads and the expiration price of the underlying will determine whether you and I are winners or losers.

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  • thanks! i corrected the error now. can you pls remove your first para. to avoid confusion if you're satisfied?
    – user44213
    May 1 '20 at 16:28
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    conversely if people only want to take one side of a trade, e.g. everyone wants to only buy puts, then I assume the MM would short the stock to hedge the put - but in that case how do they hedge their upside risk? If they e.g. buy a call then doesn't that cancel out their profit on the short side?
    – user12515
    May 1 '20 at 20:11
  • @Michael - Your question assumes that everyone is buying puts and no one is trading calls. If the options are that illiquid, hedging a few OTM puts is no big deal. The market maker could short a small amount of the stock (small relative to the delta of the put). He could do risk arbs. He could buy fewer higher delta puts at a higher strike. The reality is that in where there is any reasonable amount of option liquidity there's going to be trading in at many strikes in many weeks/months and in both puts and calls so the market maker will be arbing all over the place.
    – Bob Baerker
    May 1 '20 at 20:41

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