Happy Friday folks. Before we kick off our two-week holiday hiatus, let’s take a look into the mailbag for a question I frequently get asked…
Those stinking market makers, I tell ya! I can’t count how many times I’ve attempted to make a trade immediately following one of your recommendations to find that either the stock price and/or option price immediately moves out of the buy range.
Could you take a minute one of these days to explain how these market makers operate? I would love to hear your thoughts on this.
That’s a terrific question, Ryan.
While option market makers do have some modest influence on stock and option activity in the very short term, they’re neither as powerful nor as evil as you might think.
Most option market makers tend to trade “delta neutral.” That means they’re not looking to profit on a stock’s direction. Instead, they look to profit on the time decay of the options.
So most of the time, the market makers have no interest in moving prices one direction or another.
It might help to understand what happens when a rush of option orders hits the market…
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The market makers have to take the other side of your trade.
So, if you’re trying to buy call options, then the market makers are selling them to you. If that was all there was to it, then you’d make money as the stock goes up and the market maker would lose money.
Remember, though, market makers don’t trade for direction. They don’t want the exposure to losses if the stock goes up. So, they’ll take another trade in order to neutralize their short call position.
Most of the time, that means they’ll buy the underlying stock.
Now, imagine what happens when buy orders for thousands of call options hit the market all at once. Market makers have to meet the demand for those orders. Then they have to immediately turn around and buy the stock.
The option price moves up simply as a function of supply and demand (everybody rushing in to buy all at once). And the stock moves up because the market makers are rushing to buy in order to neutralize their positions.
If this occurs solely as a result of a newsletter recommendation, then the action is temporary. Option and stock prices will almost always come back to pre-recommendation levels within a few hours.
That’s why I always tell folks not to chase option prices…
You’ll almost always get a chance to get into a recommended trade once the initial rush to buy fades away.
Best regards and good trading,
Do you normally wait until after the initial rush to get in on a trade, or do you try to get in right away?
Let us know your thoughts – and any questions you have – at [email protected].