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How to Trade Like a Market Maker

Options market makers try to avoid risk as much as possible. One way they do that is by hedging their risk in another more liquid market. If one thinks about it, options will never be as liquid a market as the stock. For every stock, there are dozens of options and the volume must be divided among the many strikes, prices and months. Thus, the option markets will always be less liquid with wider spreads relative to the corresponding stock.

The way a market maker hedges is to look at the delta of a call option he has just bought and sell an appropriate amount of stock to hedge. Conversely, if he sells a call, he will hedge that with a long stock position. Let us assume we want to leg into a calendar spread on Chipotle Mexican Grill (CMG - Get Report), with the stock at $180.30, using current quotes as our example. We will do it using market maker hedging techniques to reduce our risk and improve our execution.

Trades: Buy to open CMG December 190 calls for $6.45 and sell to open CMG November 190 calls at $4.95.

The net debit is $1.50.

We will assume that we are using limit orders as described above, but that they are independent legs of the same trade. Currently, the December 190 call is quoted with a bid of $6.40. So, our bid of $6.45 will become the best bid and will likely get executed with a limit order. If this call is bought, then we immediately hedge it by selling 41 shares of stock because the delta of the option is .41.

In the same fashion, the November 190 call is currently asking $5.00, so our offer of $4.95 will become the best offer. If that is executed, we immediately buy 36 shares of the stock because the delta is .36.

The order of execution does not matter to us because we are immediately hedging the position. When both legs are executed, we can simply liquidate the remaining stock position leaving our desired spread. On any calendar spread, I would always set my stop profit target at the $190.00 price point for the underlying stock because that is where the peak profit will be.

At the time of publication, Phil McDonnell held no positions in the stocks or issues mentioned.

Phil is a professional options trader and contributes regular commentary to the Daily Speculations web site. Prior to trading professionally, Phil was a software developer for Dollar/Soft, a financial software company specializing in options software for equities, indexes and futures. He also wrote the book, Optimal Portfolio Modeling, which was published by Wiley Trading in February 2008.

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