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Options have now become a dominant force, significantly impacting the market's landscape. In the past few years, the volume of SPX transactions has surged remarkably. From 2019 to 2023, the total U.S. listed options volume has been growing at 24% annually, more than double the historical rate. Notably, short dated options represent a majority of the traded volume. Quite intriguing, don't you think?
Mechanics of Options Trading
To comprehend this phenomenon’s stakes, let's first unravel the mechanics of an option purchase. Broadly, two types of market participants are at play: customers placing orders to buy or sell a contract, and market makers, the liquidity providers, enabling instant purchases for customers.
Figure 1. Market Makers Act as Middleman
The market makers' primary aim is to capitalize on spreads – they buy at a defined bid price and sell at a higher ask price, pocketing the difference. Given the abundance of contracts, strikes, and expirations for SPX, approximately 20,000 contracts coexist on average. This plethora of options presents them with ample opportunities to profit from spreads on numerous contracts. However, in their role as liquidity providers, they sometimes find themselves holding residual positions.
This situation carries inherent risks, as the value of options can fluctuate significantly due to various parameters. To safeguard against potential losses, market makers engage in what we call delta hedging – a strategic move to neutralize their exposure to changing values in their options portfolio.
This situation carries inherent risks, as the value of options can fluctuate significantly due to various parameters. To safeguard against potential losses, market makers engage in what we call delta hedging – a strategic move to neutralize their exposure to changing values in their options portfolio.
The Impact of Expiration and Delta Hedging
Options exhibit more pronounced and erratic changes as expiration approaches. This phenomenon, fueled by the surge in options trading and particularly the prevalence of daily 0dte options, accentuates the exposure of market makers to options as we approach the strike price or expiration. But how can one leverage awareness of this phenomenon to their advantage?
If we can know precisely the market maker’s position, we could predict potential delta hedging flow.
Fascinatingly, the changes in market makers' delta exposure can provide valuable insights into potential delta hedging flows. The use of different option Greeks helps describe how an option contract's delta changes in response to various parameters. Specifically, Gamma portrays the delta change as the underlying asset changes, Charm illustrates the change in delta with the passage of time, and Vanna represents the delta change due to shifts in volatility.
The Limitations of Open Interest
Currently, different models exist, aiming to evaluate the market makers’ positions. However, most either lack transparency or are simply based on a largely flawed assumption:
That customers predominantly sell calls and buy puts.
While this assumption may occasionally yield favorable results, it lacks the consistency, precision, and context needed for sustainable success. In the current market climate, options have evolved into speculative assets rather than mere hedging tools, with both calls and puts being actively traded in substantial volumes.
Open interest does not provide positional insight on a given contract. It only outlines the number of written contracts for a particular option.
For every written contract, there is a buyer and a seller. They could be sold just like they could be bought by any market participant.
Figure 2. Open interest visualized
For instance, consider Figure 2. To simplify, let's assume the market consists of three participants: Customer 1, Customer 2, and a market maker. On a given day, the open interest for a specific contract is 5.
This indicates that there are 5 contracts currently 'open,' requiring both an option writer and an option buyer. Remember, this is a zero-sum game. The market maker’s position can vary significantly for the same open interest of 5—ranging from being short 5 contracts, having no position at all, to being long 5 contracts. These contracts can be distributed among any market participants. Such variability can result in a potential 200% discrepancy.
On a larger scale, this discrepancy can become substantial. Relying solely on the assumption-based model might completely overlook a large sold put position by customers. The correct approach? Accurately evaluating their positions.
This indicates that there are 5 contracts currently 'open,' requiring both an option writer and an option buyer. Remember, this is a zero-sum game. The market maker’s position can vary significantly for the same open interest of 5—ranging from being short 5 contracts, having no position at all, to being long 5 contracts. These contracts can be distributed among any market participants. Such variability can result in a potential 200% discrepancy.
On a larger scale, this discrepancy can become substantial. Relying solely on the assumption-based model might completely overlook a large sold put position by customers. The correct approach? Accurately evaluating their positions.
Identifying Aggressors
Various methods have been proposed to assess market makers' positions. One notable method involves analyzing whether a transaction occurs on the bid/ask or within the spread. This method assumes that a transaction on the ask price is sold by a market maker and bought by a customer, while a transaction on the bid is bought by a market maker and sold by a customer. This approach is more logical. However, it assumes market makers never engage in mid-market transactions. Also, large trades placed on a trading floor may take longer to be disclosed and displayed on the time/sales, potentially flawing the analysis.
The Solution?
There's no need to reinvent the wheel, as exchanges already hold the key. They meticulously track and record every trade, with detailed information on all market participants, including customers and market makers. This comprehensive tracking ensures a transparent and accurate record of market activity.
By leveraging this extensive data, we can gain valuable insights into the actual positions held by different participants. It allows us to distinguish between trades made by market makers and those made by customers, providing a clear picture of who holds which positions. This level of detail is essential for accurately assessing market makers' positions and understanding the broader market dynamics.
By leveraging this extensive data, we can gain valuable insights into the actual positions held by different participants. It allows us to distinguish between trades made by market makers and those made by customers, providing a clear picture of who holds which positions. This level of detail is essential for accurately assessing market makers' positions and understanding the broader market dynamics.
Thoughts
Open interest alone doesn't reveal the full picture of market positions, particularly those of market makers, in today's trading environment. The outdated view that customers primarily sell calls and buy puts oversimplifies the complexities of the market. By leveraging detailed exchange data, we can gain a more accurate understanding of market dynamics. In our next article, we'll explore the nuanced world of delta hedging, offering deeper insights into how these strategies influence market movements. Stay tuned for a more comprehensive look into this critical aspect of trading.
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