Option Prices Affecting Underlying value Through market makers max pain

Question

In function of the quarantine I started to dig a little deeper into the "Max Pain" principle and how market makers who write the options have to hedge the risk.

What I understood so far: Options are written by the market makers which in turn have to cover their naked option writing with the underlying value. They do this by remaining dynamic hedging to remain neutral. This causes the underlying value to be bought and sold.

This is the part where I get a little confused: If the underlying value rises then the value of a long call option will increase which causes the market makers to hedge more.

Is this done by buying more of the underlying value and therefore creating a diminish returns effect?

I also do not really understand why This rebalancing provides a force driving the stock to toward max pain.

If anybody could help me or point me into the right direction I would be really appreciative!

thanks in advance!

Answer 1

If market makers are long options (either puts or calls) , the rebalancing trades that they do tend to limit the market movement, since they are selling when markets rise and buying when markets fall. If market makers are short options (either puts or calls ), then the rebalancing trades that they do tend to exacerbate market movements , since they are buying when markets rise and selling when markets fall.

Answer 2

Effectively, your example describes a market where your market makers are not ‚atomistic‘ anymore with respect to their influence on (underlying) prices. On the other hand, MM not only employ the spot market for hedging, but also the futures market, where an increase in a ‚position‘ does not, by itself, imply an upwards pressure on the spot markets.