By buying relatively under priced and selling relatively overpriced combinations of puts, calls and unique boutique that have the same risk exposure at the same time, the market maker can take advantage of any mispricing and cancel out his risk. If the market maker can enter two or more offsetting trades that cancel out the risk and do this for a net profit then he solved both problems. When these price relationships don't hold, there is an opportunity for profit. There are few basic arbitrage spreads that determine the price relationships that the underlying stocks and their various options should have to each other. Basically, to protect sold call options market makers who sold them buy shares when the underlying's SP rises closer to the strike price, because they will have to sell 100 shares per option to the option buyer if the SP goes over the strike price. Competition among market makers often forces them to accept risks just to be included in trades, however most will not accept directional risk for more than a very short time. This spoiler forces air moving over the car to provide enough downward pressure to stabilize the vehicle and provide some degree of roll-over protection during a stock car race.


These are approximations, but I think close enough. XYZ and other institutions are now continually buying shares to hedge their bet against people like Fred, just in case they have to give him 1M shares below market value. Now XYZ buys 200k shares of Tesla. However if Tesla is at $1500 per share on Feb 7th, Fred buys the 1M shares from XYZ for $750, resells them for $1500 and makes $750M! They give him the right to buy 1M shares of Tesla anytime on or before Feb. 7th for $750. That way at least as Tesla rises, they’re protected a little in their bet, because they’ll have some of those shares, plus those shares appreciate, so it would mitigate their loss to Fred. And similary, if the SP rises, the market makers who sold put options will unwind this hedge and buy shares. Market makers quickly learn to think in terms of synthetic equivalents -alternative ways of constructing a position. Using his own appropriate current interest rate, a market maker calculates his cost of carry for the position on including the receipt of the dividend (long stock ) or the payment of one( short stock). Nearly every market maker is looking for a synthetic arbitrage trade - a trade that can be combined with other trades to produce a profit with very low risk.


If a market maker can buy stock and sell synthetic stock (or the reverse) for a net price difference that will more than cover his costs, then the combination of trades ought to make a profit with no directional risk. Looking at option positions in terms of synthetic equivalents tells the market maker his alternatives. The positions cancel because what you make on one you lose on the other. Thus by buying one and selling the other you can eliminate the most significant form of position risk, exposure to the direction of price movement. Not only is there a synthetic equivalent for owning stock, there is a synthetic equivalent for any option or stock position. Though the basic service provided by the stock brokers remain the same there are some other allied services that categories them. At expiry the combination of 2 & 3 (long call, short put) will show the same net gain or loss with any change in the stock price.


Since most stores tend to have limited stock for the very tall or large, people in this category tend to wear the same items year after year. In life, the most important thing you can have is your health. He then knows the size of the credit or debit that would make a conversion or reversal profitable, and can examine current option prices with those values in mind. As the current level of interest rates determines whither a conversion or reversal will be profitable these spreads are known as interest rate plays. The two most basic forms of option arbitrage are the “conversion” and reverse conversion or “ reversal”. In fact, this basic pricing technique is fundamental part of the way that market makers operate. While most market makers will “scalp” or “leg” into spreads on a short-term basis, trying to take advantage of moves in the underlying prices is not generally their long-term strategy. However, if you do your homework properly and thoroughly, you will reduce your risk significantly and the rewards are usually excellent, . The risk of simply taking directional bets, or taking on any one kind of exposure for that matter, is just too great; those who do don't survive over the long run.




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