FX Options: Market making options

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When you trade on a market maker's rate they are taking the risk into their own book. The purpose being to facilitate client's business and offer the best possible spreads - see our blog on why dealing direct with the market maker is the best option for trading FX - but some of our broker competitors have propagated the idea that market makers 'trade against you'.

The suggestion is obviously that you should trade with them. The difficulty there is that, if they are acting exclusively as a broker and taking no risk, they need to pass the risk directly on to someone who will i. So the risk generally ends up with a market maker anyway AND with an additional layer of cost. But the idea is out there, so let's have a close look at it.

First lets look at why market makers take risk on to their books. A market maker publishes a continuous two way rate, allowing clients to trade at the time of their choosing. Assume a market maker has a number of clients. Client one sells to the market maker, thinking the market goes down. The market maker could at this point turn around and sell to the market, as a broker would.

But then he cannot profitably show the market rate - buying from his client at the market rate and then selling at the same rate doesn't create a sustainable business, one that can continue to add value to its clients. If the market maker takes client one's trade option trading in forex market maker his book, there is now a window in which another client may show up and buy on the other side of the spread. That is why market makers take risk into their books - it is to open a window in which buyers and sellers can match off across time, allowing the market maker to capture spread as compensation for providing their service, and show a better rate than brokers.

It isn't to trade 'against' their clients. Let's look a little more closely at the period between clients one and two trading. If there is anything that gives the 'trading against' nostrum its superficial appeal, it is this period where the market maker is long and the client is short. Surely this is zero sum? If the market goes up the market maker wins and the client loses, and vice versa.

Surely the market maker is trading against client one? The market maker temporarily has an opposing position from facilitating client ones ability to trade on the best rate. But he is not married to it. He would like to see another client show up or a passive hedging order fill as soon as possible after client one trades to neutralise his option trading in forex market maker. And so we come to the issue of horizon.

Differing horizons - or holding periods - is what makes the relationship between market makers and their clients work, and gives the lie to the idea of trading against clients. Different parties can win to a trade, so long as they have different holding periods. So the option trading in forex market maker is short and the market maker long at The market maker is then paid three minutes later at 21 on a passive order.

Client one buys back his short, earning two option trading in forex market maker. The market maker earned his spread and the client was right about the market's direction and locked in his profit. So the market maker and client can in fact have a symbiotic relationship, and the market maker can facilitate the clients ability to express his trading ideas without the layers of costs of any of the alternatives.

Don't option trading in forex market maker an account? MahiFX does not provide investment advice or recommendations, and no material on this site should be construed as such. Opinions are those of the authors and not necessarily those of MahiFX, its officers or directors.

Leveraged trading is high risk and not suitable for all. You could lose some or all of your deposited funds.

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Market makers play a very important role in options trading, and in fact they exist in the markets for all kinds of different financial instruments. They are essentially there to keep the financial markets running efficiently by ensuring a certain level of liquidity. They are not your average trader; they are professionals that have contractual relationships with the relevant exchanges and carry out a large volume of transactions.

It is by no means vital that you know what market makers do, unless you have aspirations to join a financial institution and get a job as one. However, an understanding of why they exist and the effect they have is nonetheless useful.

To that effect, we have provided some further details about them on this page. The basic role of market makers in the options exchanges is to ensure that the markets run smoothly by enabling traders to buy and sell options even if there are no public orders to match the required trade. They do this by maintaining large and diverse portfolios of a wide range of different options contracts.

For example, if a trader wanted to buy specific options contracts but there was no-one else at that time selling those contracts, then a market maker would sell the options from their own portfolio, or reserve, to facilitate the transaction.

Likewise, if a trader wanted to sell specific contracts but there was no public buyer, then a market maker could execute the transaction by buying those contracts and adding them to their portfolio. Market makers basically make sure that there is both depth and liquidity in the options exchanges. In their absence, there would be significantly less transactions carried out and it would be much harder to buy and sell options. There would also be less options in the way of different contracts available in the market.

Enabling traders to execute transactions quickly, even if there is no willing buyer or seller, in turn ensures that the exchanges operate efficiently and traders can usually buy and sell the options they wish to. As we have mentioned, market makers keep their own portfolios that consist of a large number of different options contracts. They trade in large volumes and are able to buy options from traders wishing to sell and sell them to traders wishing to buy.

Without the makers, the market could easily stagnate and options trading would become significantly more difficult. In return for the important role they play in options trading, they have a major privilege within the market place which enables them to basically make some form of profit on each and every transaction they make due to the way options are priced.

There are two main aspects to the price of options that any options trader should understand. First, the actual price is made up of two main components: Secondly, and this is relevant to how market makers operate, they are priced on the exchanges with a bid price and an ask price.

Anyone looking to buy options contracts would pay the ask price of those contracts, while anyone selling or writing contracts would receive the bid price. The ask price is higher than the bid price, so an individual buying contracts would pay a higher price than the individual selling them would receive.

The difference between these two prices is known as the spread, and it's from this spread that the market makers benefit. They are basically permitted to buy at the bid price and sell at the ask price, thus profiting from the spread. If an individual places an order to buy these contracts at the same time as another individual places an order to sell these contracts, the market maker basically acts as a middle man.

Of course, it will not always be possible for a market maker to buy and sell contracts simultaneously — otherwise there would be little need for them in the first place. So they are still potentially exposed to the risk of price movements and time decay of the options they own. The primary aim of a market maker is to trade as many contracts as possible to benefit from the spread, but must also use effective positioning strategies to ensure that they are not exposed to too much risk.

Despite the inherent advantage of being a market maker offered by the spread, it's still perfectly possible for a them to lose money. Market makers are typically individuals that work for brokerage firms, banks, and other financial institutions that are specifically contracted with an exchange or exchanges, to fulfill the role. As they are not allowed to trade on behalf of public investors and traders, they must use their own capital to fund all their transactions.

They have to be incredibly skilled at what they do, with excellent analytical abilities and a lot of mental strength. When the relevant firms recruit market makers they would usually be looking for a lot of suitable experience and a clear indication of the required skill set. Market Makers Market makers play a very important role in options trading, and in fact they exist in the markets for all kinds of different financial instruments. Section Contents Quick Links. The Role of Market Makers The basic role of market makers in the options exchanges is to ensure that the markets run smoothly by enabling traders to buy and sell options even if there are no public orders to match the required trade.

How Do Market Makers Operate? Who are the Market Makers? Read Review Visit Broker.