The Role of Market Makers

Who Is Buying/Selling My Option Trade?

The seller is generally the market maker. A market maker is an individual or institution, such as Goldman Sachs, who is responsible for "making" the market by maintaining a reasonable amount of inventory of options and stock and making it available to be electronically displayed by option houses, such as the CBOE, ISE, PHLX, NYSE, etc. The market makers thus provide the liquidity by taking the other side when you go buy or sell something in your account.

The market makers couldn't care less why you are buying or selling an option. Their main objective is to make money by maintaining a reasonable spread between the bid and ask. They always buy from you at a cheaper price and sell to you at a higher price. When there are an equal number of buyers and sellers at the same strike, everything stays in check and the market makers don't need to do anything because they are just happy flipping it from one person to another constantly, while keeping the difference between the bid/ask spread as their profit on each transaction. I wish I could do that all day because it is a cash machine.

But when there is a big imbalance between the buyers and sellers and the market makers are on the hook to lose money if the stock runs in the direction traders are betting on, the market makers hedge their risk by: 1) expanding the spread between bid/ask to get compensated for additional risk, or 2) buying the underlying stock to bring their book back to Delta Neutral. This is what pushes the implied volatility higher when there is a sudden rush of buyers. There are still many other ways how maker makers hedge their risk, but essentially their goal is to always remain Delta Neutral and make money on the bid/ask spread.

Now, with that background I will also tell you that market makers are not angels. They don't always have the best interest of the trader in mind. While their function is supposed to strictly provide liquidity and maintain Delta Neutral books, they don't always do so. Understand that market makers, such as Goldman, JPMorgan, BAC, Morgan Stanley, etc. also have their own trading and investment banking arms where they are buyers and sellers like you and me. This creates a conflict of interest where they simply have better information than you, so instead of market makers maintaining a neutral position, they do not balance their books and actually take the other side and effectively bet against you.

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