When you buy an option contract, how often is the market maker providing the contract (vs. another investor)?

Question

My limited/perhaps incorrect understanding is market makers keep liquidity in options by increasing spreads in options that are less in demand, because they have to provide/make a market for them. On options on a "stock" like GLD, how often when one purchases an option, is the market maker supplying it (entering into the contract), vs. another investor?

In my option purchase decisions am I "competing" against the market maker, or other investors, to the extent one can call it competing?

Likewise when selling them. Is the option maker setting the price in his favor, because he's the one buying the options in X% of the cases? Perhaps you know of a credible reference that discusses this (i.e. not just hearsay, or have first-hand floor knowledge).

Thanks

Answer 1

There is no way to quantify "how often". It varies based on security and the volume of trades in the market at that date/time. There can be a handful or dozens of market makers for a security depending on volume. With sophisticated trading platforms, you can see the spread for any security that a market maker is posting -- they are required to openly maintain the spread. They can also make a new market any time they have a trade with no pair or existing shares already, waiting for a new buyer or seller at a price different than the existing spread (for a slightly smaller profit but faster turnover).

You are not competing with the market marker per se. They serve a legitimate liquidity function, and you net benefit from their involvement most of the time.

However, you are competing with high frequency traders and other prop traders. Especially with popular trading instruments like GLD and other highly liquid stocks, ETFs, etc., and their associated high volume options markets. They can flood markets with quotes, bids, asks, etc. and trade in and out of positions quickly while not being an official market maker. they add a similar kind of liquidity with less transparency and many papers have been written on potential price effects from all of that. The SEC has been clear that they cannot seek to manipulate prices with this activity -- whether or not they do anyway is a matter of some debate.

Answer 2

To discuss market making, it is important to understand what they were traditionally as well as what they have become.

Traditional Market Making

Traditionally, the profession of market making was designed to 'prop up' the liquidity of the marketplace throughout the trading cycle when there is not enough "natural" liquidity to keep prices efficient and accurate.

In return, market makers would be allowed to take a 'spread'. This means that they are allowed to 'Buy Low' (Bid) and 'Sell High' (Ask) at the same time and make a profit based solely on that spread. In the strictest sense, market making is not about taking directional positions - they make no assumption of where the market is going. Instead, they are only worried about the likelihood of a stock moving against them before they can exit a position (which is a risk that is compensated by the spread).

You, as a retail investor (as well as any institution that is taking liquidity for a directional position), will be doing the opposite. If you want to buy a stock, you must do so at the Ask and if you wish to sell a stock, you must do so at the bid.

I could go on for awhile about the implications of this system, but I think that is the gist.

Market Making Today

Today, market making has become much less defined and more complex. Instead of a strictly 'sell-side' affair, market making has become part of the strategy of many institutional strategies.

High-frequency trading, which another poster mentioned, very much evolved out of market making. Price manipulation is a slight misnomer for how HFT market making might affect your trades - it really should not affect your positions in the long term.

If you are looking at the markets as a long or even medium term investors, market-making & HFT will not have an affect on the fundamentals of what makes your trade a good trade. More often than not, the existence of those participants will actually help you execute your trade as well as get the most accurate price.

Sorry if I just confused you more - this stuff is not all that complicated but it can seem very daunting when starting out. It is mostly just jargon and once you are in the industry for a few years it becomes second nature -

To answer your original question

How often is it a market maker? 100% of the time. When you (as a retail investor) buy a security, you are "taking liquidity" which means that you are buying from someone who has "posted liquidity" which is another way of saying market maker.

William

Addendum

Hi Ray, in terms of market making, the stock market and the options market is actually very similar. If you hop on your TD Ameritrade account and buy a stock or an option, you will almost certainly be buying it from a market maker (or your broker will at least source it from a market maker for you). To illustrate, check out the links at the bottom of this that I just took of a trading platform. In the first one, you see some of the current options (Calls and Puts) on SPY that expire in January. As you can see, it lists the Bid and Ask price of each, just like I was talking about in my post. Above, you see the "Underlying" Big and Ask price which represents the Market Maker's pricing for stocks. If you want to Buy a stock on this platform (which is a retail trading platform), you must buy at the As and sell at the bid for both stocks and options. This is known as "taking liquidity", which is the opposite of market making which is "providing liquidity". In the second picture you see the "Depth of Book" of SPY. This shows all of the market making activity at price levels which are "deeper" than the top of book Bid and Ask Price. Although options do have market makers aside from those at the top of book, options depth of book doesn't really exist. I hope that was helpful!

http://s1071.photobucket.com/albums/u504/wyeack/?action=view&current=OptionsUnderlying.png

http://s1071.photobucket.com/albums/u504/wyeack/?action=view&current=TradeGrid.png