How do 'Market Makers' operate?

Question

I know the meaning of a market maker, but in purely practical terms, how do they operate?

Answer 1

There are market makers in a number of different markets. I am most familiar with how market makers operate at the Chicago Board Options Exchange (CBOE) so I will discuss them.

Let's say a market maker makes a market for options on GE stock. The market maker must supply a bid quote and an ask quote for every option on GE stock. The maxium spread between the two quotes is (usually) limited by exchange rules except when there is a "fast market". The market maker is required to honor an incoming order that meets his quote for up to a certain number of contracts, usually at least 20 contracts.

When an off-floor market order comes in to the CBOE, and the number of contracts is below a certain threshold, the order is processed electronically and randomly assigned to a GE market maker. A larger order buy or sell order, a spread order, or a limit order away from the quote, is routed to a floor broker. The floor broker will go to the area ("pit") where GE options are traded and request a price for the order. If he cannot get the order filled it will go to the order book official and remain outstanding until it is filled, cancelled or expires.

As for how market makers set their prices, it is largely a matter of supply and demand. If they are receiving more buy orders than sell orders, they raise their quotes on the options. If they are receiving more sell orders than buy orders, they lower their quotes on the options. In order to hedge risk factors, most market makers usually want a similar number of long options and short options. (They don't really care if the options are calls or puts since they can take long or short stock positions to convert a long call into a synthetic long put, a long put incto a synthetic long call, a short call into a synthetic short put, or a short put into a synthetic short call.)

Essentially they stay in business by controlling their risk factors (called "the greeks") and having very low cost transactions, great trading platforms, great money management, and some very helpful trading rules (such as being able to short a stock when you or I may not be able to).