Who Are Market Makers?

The image ofan open outcry pit is not unfamiliar to the American imagination,
but many people might not know who the players in that pit are.
Market makers, brokers, and the exchange staff occupy a trading pit on
an option exchange floor. Hundreds of trading pits are on the floors ofthe
world's 50 or so option exchanges, and combined, they represent the marketplace
for option trading. The exchange itselfprovides the location, regulatory
body; computer technology; and staffthat are necessary to support
and monitor trading activity: Market makers are said to actually make
the option market, whereas brokers represent the public orders.

In general, market makers might make markets in up to 30 or more
issues and compete with one another for customer buy and sell orders in
those issues. Market makers trade using either their own capital or trade
for a firm that supplies them with capital. The market maker's activity;
which takes place both on the floor of the exchange and increasingly
through computer execution, represents the central processing unit ofthe
option industry. Ifwe consider the exchange itself as the backbone of the
industry, the action in the trading pit represents the industry's brain and
heart. As both a catalyst for trading and a profiteer in his or her own right,
the market maker's role in the industry is well worth closer examination.

Individual Trader versus Market Maker
The evaluation of an option's worth by individual traders and market
makers, respectively, is the foundation of option trading. Trader and market
maker alike buy and sell the products that they foresee as profitable.

From this perspective, no difference exists between a market maker and
the individual option trader. More formally, however, the difference between
you and the market maker is responsible for creating the option
industry as we know it.

Essentially, market makers are professional, large-volume option
traders whose own trading serves the public by creating liquidity and
depth in the marketplace. On a daily basis, market makers account for up
to half of all option trading volume, and much of this activity is responsible
for creating and ensuring a two-sided market made up ofthe best bids
and offers for public customers. A market maker's trading activity takes
place under the conditions of a contractual relationship with an exchange.

As members of the exchange, market makers must pay dues and lease or
own a seat on the floor in order to trade. More importantly, a market
maker's relationship with the exchange requires him or her to trade all of
the issues that are assigned to his or her primary pit on the option floor.
In return, the market maker is able to occupy a privileged position in the
option market-market makers are the merchants in the option industry;
they are in a position to create the market (bid and ask) and then buy on
their bid and sellon their offer.

The main difference between a market maker and off-floor traders is
that the market maker's position is primarily dictated by customer order
flow. The market maker does not have the luxury of picking and choosing
his or her position. Just like the book makers in Las Vegas who set the
odds and then accommodate individual betters who select which side of
the bet that they want, a market maker's job is to supply a market in the
options, a bid and an offer, and then let the public decide whether to buy
or sell at those prices, thereby taking the other side of the bet.

As the official option merchants, market makers are in a position to buy
options wholesale and sell them at retail. That said, the two main differences
between market makers and other merchants is that market makers
commonly sell before they buy; and the value oftheir inventory fluctuates as
the price of stock fluctuates. As with all merchants, though, a familiarity
with the product pays off The market maker's years ofexperience with market
conditions and trading practices in general-including an array oftrading
strategies-enables him or her to establish an edge (however slight) over
the market. This edge is the basis for the market maker's potential wealth.
Read More: Who Are Market Makers?

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