Myth #7: Options are a zero-sum game: in order to make money, the trader on the floor who bought or sold an option has to lose for me to make money.
Fact: Very often when investors purchase options, they do so from a professional option trader (a market maker) who thereby becomes the seller of the option, and vice versa when an investors sell options.
It stands to reason that if the buyer of the option (i.e. the investor) is to make money, the seller of this same option (i.e. the market maker) must lose a corresponding amount. It appears as though public investors are in competition with the pros, and would therefore make no sense to argue with experienced, savvy market makers.
In fact, the public and market makers are not in competition with one another. The investor who purchases an option usually does so because he or she has an opinion about direction: Call buyers are bullish, put buyers are bearish. Investors purposefully establish positions with a directional bias.
When market makers sell or purchase options, it is usually because a public customer wants to buy or sell an option; market makers may have no opinion about the probable direction of a stock.
What do they do? In the best of all possible worlds, a market maker who sold an option at 2 would try to buy it back at 1-7/8, make a small profit and have no market exposure. In most real-world cases, a market maker who sells an option may not be able to buy it back quickly at a profit. What happens then, wait and hope the stock goes in the right direction?
For most market makers a wait and hope strategy would be a recipe for disaster. Instead, they will hedge their positions, either by buying or selling a different option, or many times by buying or selling the underlying stock or security. It turns out that investors and market makers are not competing against one another:
investors are trading a directional opinion, while market makers are hedging their positions and trying to lock in small profits due to small price fluctuations in a series of options and the underlying security.
Back to Archive