[JumpCrisscross]

We had a contract with a retail brokerage under which we paid them a fixed monthly fee plus a fraction of the flow they sent us in exchange for being their exclusive options market maker. We had to execute the trade at the national best bid and offer (NBBO). We made the difference between the NBBO and whatever we managed to execute at. These are contracts negotiated between broker-dealers, so a relevant attorney would be your best source of information.

[jordanb]

Could you go into more detail about the difference between the NBBO and what you were able to execute at?

My understanding is that the NBBO is, by definition, the best executable price. If you're able to execute for a better price then the price you paid was the NBBO.

[JumpCrisscross]

Most trades will execute at something near but worse than the instantaneous NBBO.

Let's say the market is 147.05 at 148.30 (I, as the market maker, am willing to buy at 147.05 and sell at 148.30). That's the NBBO. If someone IMs me and says they're willing to buy at 147.10, that moved the market and thus the NBBO. I am required, by law, to report that trade to the consolidated tape.

But if someone IMs me and says they're willing to buy at 147, that's worse than the NBBO. I would then consider lifting at 147 and selling at 147.05. Why would someone buy at worse than the market? Maybe the market was 147 when they put in the order and their computers were slow to catch up. Or maybe they're George Soros placing a multi-billion dollar bet and know that if they put an order into the NYSE it's going to execute at much worse than 147. Either way, I functioned as a market maker by taking their problem and making it mine.

[foobarqux]

Did you mean to say that the person in the second example is a seller? (147 is cheaper for a buyer than 147.05, the NBBO. You "lift" an ask not a bid).

[PhantomGremlin]

It would be nice to hear from him how often he executed "inside" NBBO. That's easier to do in spread trades than in simple puts and calls.

Also note, he said he was acting as a MARKET MAKER.

E.g. let's look at where a particular AAPL option closed on Friday:

AAPL131221C00550000 9.65 bid 9.85 ask

Another, bigger difference because it's further in the money:

AAPL131221C00500000 54.15 bid 55.20 ask

Another, bigger difference because it's further out in time:

AAPL150117C00550000 bid 65.50 ask 66.40

The market maker buys at bid, sells at ask. If he can do that thousands of times a day in a thousand different securities, the profits start to add up.

Doing this in options means the market maker needs to be quite nimble, even more than with stocks. This is because he's buying or selling a DERIVATIVE and the UNDERLYING security can change in price quite quickly.

But that's why these guys buy fast computers and why they pay smart people the big bucks to write software for those computers (and to e.g. program FPGAs for high speed trading).

[noname123]

Option bid/ask spread is much wider because 1) notional value is 100 shares as opposed to 1 share of stock, 2) has an additional mysterious value, volatility in the option pricing formula, 3) for OTM options, has volatility simile aka "black swan" properties that elevates the pricing and spread higher.

It's not as easy to make money being a options marketmaker because you have to realize not all of your trades will be someone taking your bid/ask. Even so, you'll have delta-hedge your position with the underlying which is a imperfect hedge that is subject to jump risk. Typically a AAPL options marketmaker is taking orders from traders and has up to couple hundred of these AAPL with long name positions, and they have to balance out the greeks, delta and gamma. They may even have to buy some options themselves to hedge themselves and pay the market price.