Times are difficult for option market makers. Market-making profitability is largely a function of volume, ideally with a multiplicity of views generating that volume. A market maker can only hedge in an intelligent fashion, if a product has enough volume spread throughout different months and strikes. It's much more difficult to hedge their risk if the only orders they are seeing are from the large proprietary desks of the world.

The profitable two-sided customer order flow the floor used to see is now being internalized. This happens when broker/dealers trade against customer order flow instead of exposing it to the exchanges. Several firms have recently hired top institutional salespeople to gain access to more of this desirable order flow.

The drying up of customer order flow is best exemplified by the rent for a seat on the American Stock Exchange. Current seat lease prices, a good indicator of the profitability of the market maker, are $1,100 a month. This is a fraction of the $18,000 a month they were fetching at the 2000 peak. There are plenty of seats available, as many market makers have left the floor.

Summer Volatility

It's within this environment that the entire dealer community seems long summer premium. Every option order being shopped around is from a buyer of summer premium. One-sided order flow creates added risk -- it reduces opportunities for dealers to hedge their positions effectively.

If complacency settles in, there will be an overhang of supply from dealers looking to sell summer option premium. Barring another market meltdown, this overhang could compress premiums further during the historically quiet summer months. Prior to 2002, option market-making firms were penalized by being long premium during these months. In the summer of 2001, firms took huge losses, and smaller firms were forced to consolidate. In the summer of 2002, they also were long premium but were saved by the market meltdown.

Market makers are working so hard to forecast volatility that they are acting quicker to cover their positions and reverse course. This activity is exacerbating the volatility of the VIX.

Some volatility traders are starting to take the contrarian view in names such as Boston Scientific ( BSX), Intel ( INTC), Pixar ( PIXR), Sears ( S) and Texas Instruments ( TXN), and starting to buy calendar spreads (long fall, short summer), thus causing the term skew to flatten. Was the summer of 2002 a harbinger of things to come, or will we return to the quiet period of previous summers?

Paul Haber is an options strategist and portfolio manager at Kramer Capital Management, which manages $60 million in hedge fund and other individual accounts and uses equity and equity options to optimize the returns on its portfolios. At time of publication, Haber held no positions in any of the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While he cannot provide investment advice or recommendations, he welcomes your feedback.

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