neroden
Model S Owner and Frustrated Tesla Fan
You're the expert, so let me pick your brains here. This is what I know; tell me what I don't know.Actually, a lot of this is incorrect .
Market makers almost what's trade roughly Delta neutral. We make our money on trading volatility.
First, it's flat-out impossible to stay true delta neutral with options unless you actually find a buyer for every seller and end up with no positions. You can hedge your delta, but you can't make a perfect delta hedge, because delta changes. (As measured by gamma.) Any major move requires a rehedging.
Market makers in stocks do actually try to net out to zero positions at the end of the day every day, but I've been told that market makers in options generally end up with an imbalance, and that the imbalance generally:
(1) means that they are net short in both calls and puts
(2) means that they are net short more calls than puts
I was led to believe that the long-term reliable income streams for the options maker were (a) the spread, like stock market makers, and (b) theta decay, which is why they don't balance their positions.
I've been told this imbalance is generally hedged by buying stock.
If the stock price jumps up so that deep out-of-the-money calls become deep in-the-money calls, the market maker goes from having a short DOTM call position hedged by a small stock position (low delta) to having a short DITM call position which must be hedged by a *much larger* stock position (delta of 1). In short, they're forced to buy a lot more stock in order to maintain a delta hedge, Now, if they were primarily short puts rather than calls, they'd be selling more stock to maintain a delta hedge, but I am told that normally they sell more calls than puts.
In short, if options market makers are in the normal position (net short calls and puts, but short more calls than puts, and "normally" delta-hedged), then a massive price spike means they have to buy tons of stock.
Now, you're saying options market makers make money on volatility. Well, technically, anyone who is a net seller of options makes money on volatility, because options are insurance against volatility. I guess you make more profits selling options when IV is high than when it's low; as a seller of puts, so do I. But what you're saying here makes no sense to me:
Spreads will certainly increase, but market makers will be trying to get long vol if they aren't already at that tube, so they will be buying ATM options . Calls and puts are equivalent in terms of vol, so they will be buying each as much as they can ATM. any market maker that tries to stop opening positions until things calm down is awful at what they do.
What I don't see is how you can possibly make money by buying ATM options at high volatility. Thought experiment: volatility spikes and the stock price doesn't move. You pay a fortune for inflated-price options. Volatility drops, so the options you bought then drop in price and later expire. How is this supposed to work? Please explain what you mean, because what you wrote makes no sense.
To make money you sell at high IV, not buy. Or did you mean buy *before* the spike? Because buying after the spike makes no sense.
Market makers make a significant portion of their profits when vol spikes. For instance this February when *sugar* hit the fan I know of 2 firms specifically that made more in those 2 days than the entire previous year.
Market makers don't have unhedged/exposed positions at least in terms of Delta. Any firm short vol will be racing to buy vol to avoid hitting risk limits.
Now they will also need to be balancing things like gamma and skew, so I can't predict what type of buying or selling activity will happen in the wings, that will be up to their current exposure and the way the smile curve is changing. They will generally just try to keep things in line with the curve and flatten out wing risks.
Fair enough, but the whole point is that a true short squeeze is a wing risk being realized that day at high speed, when it's too late to hedge it and the only hope is to cut your losses. Delta hedging is incomplete because it only protects against small moves. If the stock does a jump from $300 to $600, anyone who's merely delta-hedged is screwed, and it's impossible to have a complete gamma hedge when you're net short calls and net short puts.
Of course I don't actually know that the market makers in Tesla are net short calls, net short puts, or short more calls than puts; this is simply the typical market situation, or so I'm told. The situation would be quite different if they are (for instance) short more puts than calls due to the state of non-market-maker options demand, or net long puts due to an influx of non-market-maker put sellers, or whatever. I suppose I could actually try to figure out their put vs. call exposure situation by looking at the open interest, though it still requires guesswork in terms of figuring out how strong the non-market-maker write side is.