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Suppose a stock is currently at 100. If there are more willing buyers of a stock (retail investors, institutionals etc.) at $110 than sellers (also retail investors, institutionals etc.), you would expect the stock to gravitate towards the price at which there is a balance between the buyers and sellers of that stock. Furthermore, if the stock was a microcap, and have few shares outstanding, and low volume on any given day, large institutionals have a limited way of participating in the upside of the stock (i.e. at most they can buy the entire company).

Now consider an American style option on public company like (AAPL or GME). If I buy a call option on GME, based on my understanding, in most cases, it is a market maker on the other side of the trade, selling me the call, and hedging appropriately with GME shares.

  1. Does this mean that the options market's depth, even on a small company like GME is much greater than the underlying? In other words, does this mean that market makers will continue to buy or write options to the market's satisfaction without constraint (and without pushing up the price) like there is in the case of equities, where you are limited by the number of shares outstanding?

  2. And if 1 is correct, does this mean that the market maker's view on the options "correct" pricing is what drives the option's pricing? For example, if an options market was extremely illiquid, and there were really only 2 players, Party A who is bullish on the price of the option, and Party B who is bearish. If Party A is willing to bet more on his view, then does the price of the option rise? Or is this largely negated by the market maker, in the sense that even if Party A's bets dwarfs Party B, there will always be the market maker who keeps the options price close to what the market maker thinks it should be priced at.

If there are any resources that one can point to to help me understand the mechanics / plumbing of how "price discovery" works for options, that would be great.

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When you market-make anything, you definitely take liquidity into account via the bid-offer spread (and via Implied Vol when you quote options). So if the underlying that you need to hedge with is not liquid like GME, the bid-off spread on the option will be larger than on options that have liquid underlying. Also the premium of the option (expressed as Implied Volatility) would be much higher on GME options than on blue chip stocks (think of this premium as a % of the price of the underlying; if you took a blue-chip stock with the same price as GME, and considered two options with the same maturity and strike, the mid price of the option on GME would be much higher. In addition, the bid-offer spread on the GME option would be wider).

As far as 2) is concerned, the market maker's view is definitively a driver in the option price. If all market makers started believing that GME stock will go down, they would be happy to sell calls at near mid prices (of the bid-offer spread). But the demand is a bigger driver: if the market-maker gets asked to sell 1000 calls when the GME price is (say) 400 and he believes the price of GME should go down, he'll quote option price near mid. If he keeps being asked and the market comes to him another 10 times with the same demand, he'll not want to keep increasing his risk exposure and will start quoting higher bid-offer spread as well as higher implied vol of the call option, driving the option price up.

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  • $\begingroup$ Just to follow up on 2) then, is it reasonable then to conclude in an analogous way, that if one believes that illiquid stocks with little coverage or following are more prone to mispricing, that the same can be said about illiquid options?It appears so based on what you're saying, since the market maker's view seems primarily driven by demand and supply of Party A and B, and market makers can't possibly take a fundamental view of the company and recognize when a catalyst is going to occur. $\endgroup$
    – Snowball
    Feb 6 at 23:58
  • $\begingroup$ @Snowball: Yes, I would agree with what you're saying. Market-makers can take a fundamental view, but they are limited by the size of the risk they can take on: that's why when a market-maker has a different view to the flow of the market, he can only "fight the market" for limited period of time (until he's "stopped out"). $\endgroup$ Feb 7 at 11:35

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