A web-reading bot made millions on the options market

A web-reading bot made millions on the options market
slate.com

It doesn't matter that it is a bot. The controller of the bot happens to be, in this instance, directional order flow: unlike the overwhelming majority of market volume, he actually has an edge.

The options market maker is, unusually for market makers, forced to transact with any comer. They've got a license to print money and that is the price of the license. They get to pick their pricing.

In the old days, when people actually talked, parties would be cagey about whether they were buying or selling, to make sure the market maker didn't use that against them. The conversation went like this:

"Make me a market [quote a buy price and a sell price] for 100 contracts of May Foo CALLs at $15."

"0.10 by 0.15."

"Buy a hundred."

"Done."

"Make me a market."

"0.10 by 0.15."

"Buy a hundred."

"Done. #'(%# you man what's your angle."

"Make me a market."

"0.11 by 0.16"

"Buy a hundred."

"Done, you mother(#%)0&. You want WEIGHT? I hate carrying this. Next one is 0.20 by 0.25"

"Buy a hundred."

"DONE. You through with me yet?"

"Make me a market for 1,000 contracts."

"YOU MOTHER()#%0# #O%'#(&')$#$ ((#) '%)(#%). 0.30 x 0.35."

"Buying 1,000."

"DONE YOU #%)0#0%)."

And the reason the marketmaker just hated that interaction is because they now have what is politely referred to as "inventory risk." Market makers by definition don't want exposure to the market, they just want to harvest non-directional order flow, where buys and sells roughly cancel each other out, capturing the spread each time and making out like bandits. (In the case where the market maker's second conversation was someone selling the same option rather than buying, they just made $500 for about a minute total of work. A "seat" on the CBOE, which is the license part of the license-to-make-money, costs millions. The lucrative ability to collect a little toll from marker participants is why.)

But once in a while, you get stuck with inventory risk. And, if you're stuck with inventory risk by being short in grossly out-of-the-money call options close to expiry, the vast majority of the time that's great news! They expire worthless.

But they don't have to expire worthless. There's literally thousands of contracts which expire every month worthless, and (statistically speaking) a handful which go from being worth pennies in the morning of expiry day to being worth dollars in the afternoon.

You probably shouldn't feel badly for the options market maker here, except in the general sense that you should feel badly for people who underperform at their jobs. He's suppose to place orders that he'll be happy when the fills come in. (i.e. When his offer to sell a call option is matched with someone who inexplicably wants to buy them at a penny a contract.) He got the fills.

His problem is that a counterparty was smarter than he was and put in buy orders in response to late-breaking information before he could cancel his sell orders. Which is unfortunate, from his perspective, but avoiding this is literally his only job.

This is, incidentally, the whole premise of Flash Boys: people with lots of stock to shop are the guy getting sworn at in the above conversation with a marketmaker. They would prefer that marketmakers always buy 100k shares from them at a go without experiencing any price slippage. Market makers do not like this, but can't do much about it. HFTs are much better at making markets than humans are, and are capable of managing the risks of large block trades better. Some people who preferred getting an exceptionally good deal from human market makers would prefer dealing with them instead of algorithms which can actually, you know, do math many times a second for an entire trading day.