The players in the game
Many option traders don’t understand who might be buying or selling the options on the other end of their transaction. Fortunately, after reading this, you won’t be one of them.
Buying or selling an option is a process quite similar to buying or selling stock. It’s not some mystical process just because it’s a different type of security. In fact, it trades pretty much like any other security.
In the option market, you’re dealing with four different entities: retail investors like you, institutional traders, broker-dealers and “market makers.” The generic term “trader” is often used interchangeably for any of these players.
Orders generated by each player are routed to entities called “exchanges”. You probably already know how exchanges work. But figuring out just how options change hands can be a little confusing. So let’s take a look at just who each player is, then we’ll look at how your option orders get executed.
Retail investors are individuals like you who are buying and selling options with their own money for personal profit. Their objective is usually to make a significant percentage gain on their initial investments. Normally, individual retail investors will be trading on a smaller scale than other players in the game.
Institutional traders are professionals trading for large entities like mutual funds, hedge funds, etc. Oftentimes they will trade options to hedge their positions, but they may also trade options as pure speculation.
Broker-dealers are in the game to facilitate trades. These are firms like TradeKing, that accept orders on behalf of clients and then ensure they are executed in the open market at the best available price. This is done in exchange for commissions on the trade. In addition to facilitating trades, a dealer may also choose to buy or sell options for its own benefit, whereas a regular broker won’t. So the combined term “broker-dealer” encompasses all of the players that serve these functions.
Market makers are the 800 lb. gorilla in the game. They’re obligated to make bids and offers on the options traded on specific securities. Thus, market makers provide liquidity in the options marketplace.
In other words, market makers stand ready to take the opposite side of a trade, if and when one of the other players wants to buy or sell an option. Market makers provide a firm bid and ask (offer) price in order to facilitate trading on that option.
In theory, market makers earn their profits from the difference between the bid and ask price of options. They try to continually buy at the bid price and sell at a higher ask price, so they’ll make a few nickels or dimes on each transaction. And when you’re making as many trades as a market maker, that loose change can really add up. In practice, the picture is a little more complex. But for now, the above scenario is all you really need to know.
Exchanges exist to maintain a fair and orderly marketplace and to provide timely dissemination of price information. Any time you place an option order, it is routed to an exchange, where buyers are matched with sellers. Exchanges can be either a physical “open outcry” location where traders meet to conduct transactions or an electronic platform.
So who's on the other side of my option trade?
When you enter an option order with TradeKing, we look in the marketplace for the national best bid or offer price for your trade. Your transaction is then matched with the entity providing that bid or offer.
Much of the time you will be trading with a market maker. However, you may instead wind up trading with an institutional trader, a dealer, or another retail client. It really makes no difference who you’re trading with, as long as your order is executed at a favorable price.
Ultimately, what this all means is that there will always be a market for any exchange-traded option you would like to buy or sell. You may not always like the market for a given option, but rest assured it will always be there for you to participate in should you choose to do so.