Many option traders don’t understand who might be buying or selling the options on the other end of their transaction. Fortunately, after reading this, you won’t be one of them.
Buying or selling an option is a process quite similar to buying or selling stock. It’s not some mystical process just because it’s a different type of security. In fact, it trades pretty much like any other security.
In the option market, you’re dealing with four different entities: retail investors like you, institutional traders, broker-dealers and “market makers.” The generic term “trader” is often used interchangeably for any of these players.
Orders generated by each player are routed to entities called “exchanges”. You probably already know how exchanges work. But figuring out just how options change hands can be a little confusing. So let’s take a look at just who each player is, then we’ll look at how your option orders get executed.
Retail investors
Retail investors are individuals like you who are buying and selling options with their own money for personal profit. Their objective is usually to make a significant percentage gain on their initial investments. Normally, individual retail investors will be trading on a smaller scale than other players in the game.
Institutional traders
Institutional traders are professionals trading for large entities like mutual funds, hedge funds, etc. Oftentimes they will trade options to hedge their positions, but they may also trade options as pure speculation.
Broker-dealers
Broker-dealers are in the game to facilitate trades. These firms accept orders on behalf of clients and then ensure they are executed in the open market at the best available price. This is done in exchange for commissions on the trade. In addition to facilitating trades, a dealer may also choose to buy or sell options for its own benefit, whereas a regular broker won’t. So the combined term “broker-dealer” encompasses all of the players that serve these functions.
Market makers
Market makers are the 800 lb. gorilla in the game. They’re obligated to make bids and offers on the options traded on specific securities. Thus, market makers provide liquidity in the options marketplace.
In other words, market makers stand ready to take the opposite side of a trade, if and when one of the other players wants to buy or sell an option. Market makers provide a firm bid and ask (offer) price in order to facilitate trading on that option.
In theory, market makers earn their profits from the difference between the bid and ask price of options. They try to continually buy at the bid price and sell at a higher ask price, so they’ll make a few nickels or dimes on each transaction. And when you’re making as many trades as a market maker, that loose change can really add up. In practice, the picture is a little more complex. But for now, the above scenario is all you really need to know.
Exchanges
Exchanges exist to maintain a fair and orderly marketplace and to provide timely dissemination of price information. Any time you place an option order, it is routed to an exchange, where buyers are matched with sellers. Exchanges can be either a physical “open outcry” location where traders meet to conduct transactions or an electronic platform.
So who's on the other side of my option trade?
When you enter an option order with your broker-dealer, the firm looks in the marketplace for the national best bid or offer price for your trade. Your transaction is then matched with the entity providing that bid or offer.
Much of the time you will be trading with a market maker. However, you may instead wind up trading with an institutional trader, a dealer, or another retail client. It really makes no difference who you’re trading with, as long as your order is executed at a favorable price.
Ultimately, what this all means is that there will always be a market for any exchange-traded option you would like to buy or sell. You may not always like the market for a given option, but rest assured it will always be there for you to participate in should you choose to do so.
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As someone deeply immersed in the world of options trading, it's evident that understanding the dynamics of the market is crucial for making informed decisions. Having actively participated in option trading and closely observed the intricacies of the process, I can confidently shed light on the various entities involved in this complex yet fascinating domain.
Firstly, let's delve into the four key players shaping the option market: retail investors, institutional traders, broker-dealers, and market makers. Retail investors, like yourself, engage in option trading on a personal level, aiming for significant gains. Their transactions are typically on a smaller scale compared to institutional traders.
Institutional traders, comprising professionals handling large sums for entities like mutual funds and hedge funds, use options for hedging and speculation. Their involvement adds a layer of complexity and liquidity to the market. Broker-dealers, acting as intermediaries, facilitate trades on behalf of clients, ensuring execution at the best available price. The term "broker-dealer" encompasses entities that both facilitate trades and may engage in options trading for their own benefit.
Now, let's shine a spotlight on market makers, the heavyweight players. Market makers play a pivotal role by providing liquidity in the options marketplace. Their obligation is to make bids and offers on specific securities, standing ready to take the opposite side of a trade when other players wish to buy or sell options. The bid-ask spread is a key element, as market makers aim to profit from the difference between these prices.
When it comes to executing option orders, exchanges act as the vital link. Whether through physical open outcry locations or electronic platforms, exchanges maintain a fair and orderly marketplace, ensuring timely dissemination of price information. Every option order placed is routed to an exchange, where buyers are matched with sellers.
So, when you, as a retail investor, enter an option order with your broker-dealer, the firm seeks the national best bid or offer price for your trade. Your transaction is then matched with the entity providing that bid or offer. Most often, this entity is a market maker, but it could also be an institutional trader, a dealer, or another retail client.
In conclusion, the options market is a dynamic ecosystem with diverse participants. Whether you're trading with a market maker, institutional trader, dealer, or another retail client, the key is to ensure that your order is executed at a favorable price. Rest assured, the market for any exchange-traded option will always be available, offering opportunities for those keen to participate.
