I have always been curious about what a market maker does to protect against a situation where many calls or puts are sold by the market maker and the market moves or is moving against the position of the writer of those options (say, the market maker).   There is a great deal of exposure.  So what does a market maker do to protect the market maker either at the time of the sale of the options or when the market is moving against the position of the market maker?
Thank you.  

Dave


Dave,

1) The first step is to slow down, or stop selling more than a few options at one time.

2) Next, raise your bid on all options and raise the offer.  That way, you have the highest bid and thus, a chance to buy options.  But, you also now don't have the lowest offer, so you won't be selling any more options.

3) If an independent market maker, and there are few of these remaining, buy some index options (an index appropriate for the stock you are trading) to get some positive gamma and vega.  To minimize risk, buy these with the same expiration as the options you are selling.

4) Most MMs today are not independent and work for a trading company.  The MMs job is to trade the options and ignore risk.  That's because the partners, who run the risk management software from an office, are constantly monitoring the risk of each of their floor traders, and they (their computer software) is able to make adjustment to the portfolio very frequently to mitigate risk.  In other words, it's done for the MM and he/she doesn't not have to be concerned.

Mark

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Mark D. Wolfinger


blog: http://blog.mdwoptions.com/options_for_rookies