Who is on the Other Side of Your Option Trade?

When you click the “Buy to Open” button on your option trading platform, from whom are you buying? And does it matter? Well yes, it does matter. It can affect the price you pay for the option, to the degree that it might make the difference between a winning trade and a losing one.

The options market is made up of multiple exchanges. Each exchange hosts many options “market makers.” The market makers are broker/dealers, whose job is to buy options wholesale and sell them at retail. These dealers are always present in the market.

The market makers’ computer systems make sure that they have a bid price and an offered price in the market at all times for all the options they deal in. This is true whether any trades have taken place in each option or not.

Their presence explains why the option chain for each stock is fully populated. All the market makers are constantly transmitting their bid and ask prices to their exchanges.

The exchanges co-operate in a committee called the Option Price Reporting Authority (OPRA), which aggregates all the data and feeds it out to the public through data vendors.  What we see on our option chains is the result of this aggregation and dissemination from OPRA.

This includes bids and offers from all of the option market makers, as well as from all other traders, including you. We see just one number as the “Bid” for the option and another for the “Ask.” But these are just the best (highest) bid and the best (lowest) ask price available among the many bids and asks from all the players.

That is what happens with options that are widely traded. Below is an illustration:

Above is the option chain for the exchange-traded fund QQQ. This is one of the most actively traded assets in existence, and its options likewise have a great deal of activity.

Notice the columns labeled “Volume” and “Open Interest.” The quantities there are in the thousands or tens of thousands. Volume is the number of option contracts that have traded today. Open Interest is the total number of contracts in existence for the given strike price. The fact that these numbers are very large indicates a great deal of activity, presumably by many different traders. This explains the narrow spreads.

So for the QQQ, the answer to the question, “Who is on the other side of your trade?” could very well be – “another trader.”

Now contrast this with a different ETF at around the same price:

Above is the option chain for the Pharmaceuticals ETF, whose symbol is XPH. It is trading at $95.60, about the same price as QQQ. But look at the bid-ask spread on the options. The $96 calls are Bid at $1.10, while the Ask is $1.55. Instead of one cent, that spread is $1.55 – $1.10 = $.45. This is a humongous 41% of the bid price.

We can see above that in stark contrast to QQQ, this ETF has very low numbers for Volume and Open Interest. The annual traders’ convention for these options could be held in a broom closet. With so few people participating, in most cases we would be dealing with the market makers, and there might be very few even of them.

So on this asset, the answer to the question, “Who is on the other side of your trade?” is almost certainly “a market maker.”

So to put it in a nutshell:

Stick to assets whose options have a large amount of volume and open interest. Don’t be the pigeon in the only game in town.

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The Flying L Trader, July the 25th