What is a Market Maker?

When you Trade, who is on the Other Side?

Stock Market
Stock Market. Google Images

A market maker is a securities dealer who undertakes, at all times, to buy and sell ,at ever-changing prices, each of the options on any given stock. Note the phrase: "at all times." That means that the market maker cannot fulfill his/her obligations by buying or selling options whenever it suits him/her. By being granted market maker status, the trader has an obligation to be available to buy options from sellers, or to sell options to buyers -- especially when there is an influx of orders and others and demand or supply is unusually high.

in simpler terms, the market makers have an obligation to maintain an fair and orderly market.

The difference between the bid/ask market quotations of a market maker and a customer (such as you or me) is simple: You bid only for specific options that you want to buy or you set an ask price only for those specific options that you want to sell. In addition, you can establish a limit price with no obligation to satisfy the buy and sell orders of any other person in the marketplace. The market maker has the obligation to continuously display a bid and ask price.

Whenever you enter an order to buy or sell a specific option or an option spread, the order becomes visible to the market makers. At one time, those market makers were gathered together in a trading pit on the trading floor of one of the option exchanges, such as the CBOE or AMEX. Today, those "trading pits" are populated by computers, and not live traders.

Each of those computers is controlled and operated by a market maker who competes for customer order flow (i.e., the ability to trade with the customer orders). In return for this beneficial and profitable order-flow access, the market maker must fulfill their obligations.

Whenever your buy/sell is not filled immediately, and when your bid is the highest published bid price, or your offer becomes the lowest published ask price, that order becomes visible to the world.

On other words, the market makers cannot hide your bid/offer (which would make it more difficult to fill) from everyone else.

Making the Trade

The computer program that contains your order is constantly scanning every displayed bid and ask price for the option identified in for your limit order. As soon as a matching price is found, the computers "agree on the quantity and price" and the trade is executed. The trade occurs between your broker's computer program and that of any other market participant. Most of the time you will trade with a market maker, but if another customer is offering to sell at your bid price, then you will trade with that customer (via his/her broker). The mechanics of the trade are identical, and it never makes any difference with whom you trade.

If the executed trade contains enough contracts to complete (fill) your order, the process ends and the trade is reported to you. If you traded fewer contracts than desired, then you are notified of a "partial fill" ("partial" for short) and the remainder of your order remains live until it is filled or canceled. 

The Exercise and Assignment

Once the trade occurs, the buyer and seller are separated. The Options Clearing Corporation (OCC) takes over from this point forward and guarantees that all option contracts will be honored.

If the option owner exercises his/her rights to buy/sell 100 shares at the strike price, then the OCC randomly selects one brokerage firm andto that broker. In turn, the broker randomly selects one if its clients who has a short position in that option -- and that account is assigned the exercise notice. The "trade" that converts any option into a stock position occurs overnight, and the person assigned the notice learns of the assignment before the market opens for trading on the next business day. Clarification: This process eliminates the worry that the person who sold the option may no longer be able (financially) to satisfy the conditions of the contract. In other words, if the option is ever exercised, the OCC guarantees the option.