Options market making involves trading both underlying and derivatives. This requires the market maker to deal with thousands of positions simultaneously. In addition, they must impose factorial stochastic volatility models on the underlying asset. In addition, they must also solve highly dimensional problems. Also, they must meet client requirements within a given time.
Options market making is among the most challenging jobs on Wall Street. The implied volatility for most trades is historically low, and profit margins are slim. The process is further complicated by the exchange rules. Dealers must post bids and offers in a byzantine market structure. The result is a lack of liquidity in the market.
Market makers play a key role in maintaining liquidity and depth on the options exchange. Without them, the options market would be very illiquid and trades would be less efficient. Moreover, their jobs ensure that the exchanges run smoothly and ensure that investors can buy and sell options in the shortest time possible.
Options market making requires certain rules and regulations. A Market Maker may not execute more than 25% of the total options contracts in a series. The Exchange may choose a time frame when the alternate lead market maker will be allowed to operate. This time period must be less than one year. If the market maker fails to do so within the designated period, the exchange may reallocate the options class to another market maker.
A Lead Market Maker is an individual who engages in trading in options on the Exchange for their own account. As a Lead Market Maker, their transactions must contribute to the continuity of prices and minimize the effect of temporary disparity between supply and demand on the market. If a Lead Market Maker is not an approved person in a Lead Market Maker member organization, they may not be permitted to participate in options market making.
An electronic Market Maker is required to update quotations in response to changing market conditions. This market maker must also maintain an active market for options, including those orders that are routed to other markets. They must also honor orders attributed to them. If the electronic Market Maker is unable to meet these requirements, they must terminate the transactions.
The use of equity options by institutions is growing. In a recent SEC filing, 720 institutions filed 13-F option reports. This means that options are increasingly used by institutions to protect their portfolios. The low volatility environment in the market has spurred the use of strategies that generate alpha and protect portfolios. It has also led to the conversion of some equity-only desks to multi-asset trading. Furthermore, the use of weeklies and shorter duration options by buy side firms is becoming increasingly popular.
Market makers need to invest huge amounts of money to remain competitive. A typical firm investing $100 million or more is required to launch a market-making business.