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In the book McMillian on Options the author states that in some cases an option market maker hedges himself by purchasing longer dated options. Unfortunately, the author does not go into detail why the market maker does that. I was unable to find on the internet literature that this is actually true. I was wondering if someone could confirm this and explain why this is the case?

Edit: Rephrased the question.

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  • $\begingroup$ Sounds like a calendar spread..this position will carry the same risks and rewards as a calendar spread would $\endgroup$ – nimbus3000 Jul 23 '17 at 19:25
  • $\begingroup$ Thank you for your reply. I did not think about a calendar spread. However, it does imply that. $\endgroup$ – Clifford Jul 24 '17 at 17:42
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McMillian's example does not make sense to me. Typically short-dated contracts are liquid and longer expirations are less so, and it would make sense to hedge long-expirations contracts with more liquid (also typically tighter, and more leveraged) short-term ones, but not the other way around.

The only explanation for this, is maybe by "hedging" he meant just laying off gamma/vega risks against flow, and not (what I would call) actively hedging by crossing the spread.

Source: I'm a former OMM. Don't know any literature that describes things like that.

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  • $\begingroup$ Oké thank you for your reply. That would make indeed more sense. Great to hear that from an (former) OMM. That is a cool job! $\endgroup$ – Clifford Jul 25 '17 at 8:54
  • $\begingroup$ May I ask that as a former OMM have you actually done that yourself: hedging against longer term options, by means of short term options? If so would you please explain why you did that, instead of using the underlying? The motivation for asking is because I mostly read that an OMM sells a call and hedges himself by means of the underlying. $\endgroup$ – Clifford Jul 25 '17 at 14:18
  • $\begingroup$ @Clifford, I understand your question better now. Here's what happens - the first order risk - delta, is always hedged with the underlying when a new trade comes in. McMillian, and me in the answer above, just don't not mention the delta hedge. McMillian is saying that he does vega hedge with long term options in addition to his delta hedge. $\endgroup$ – onlyvix.blogspot.com Jul 27 '17 at 10:24
  • $\begingroup$ I know that the vega component of an option is higher for longer dated options, but I do not understand why it is hedged. Because the vega becomes smaller when time progresses. I do not see how the vega is neutralized. $\endgroup$ – Clifford Jul 30 '17 at 15:49
  • $\begingroup$ You have 2 main nonlinear risks - vega and gamma $\endgroup$ – onlyvix.blogspot.com Jul 31 '17 at 18:47
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Toughest challenge you face as a market maker is inventory risk. To sell something, you should own it. Time between buy and sell is never zero and you have same exposure against market as any other participant.

Taking advantage of calendar spread makes you market neutral, but you still have place for profit.

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  • $\begingroup$ "To sell something, you should own it." ? You have a lot to learn. $\endgroup$ – onlyvix.blogspot.com Jul 27 '17 at 10:29
  • $\begingroup$ When you sell for some price, you shouldn't own it, but you make an obligation to deliver. Eager to learn more @onlyvix.blogspot.com $\endgroup$ – yety Jul 27 '17 at 19:29

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