In a live example: Today is June 14, 1 hour before market close, and \$SPY (S&P 500 ETF) is currently at \$372.28 and the June 15 \$350 strike Put is being quoted for \$0.13 on the bid and \$0.14 cents on the ask. The IV is 39.00%.
The $350 strike is currently 5.98% away from the spot/ATM price.
An implied volatility of 39% means that $SPY must realize a minimum of 2.45% volatility for the MM to break-even, and more than that for the MM to profit.
0.39*sqrt(1/252)*100 = 2.4567...
Let's say many traders come into the market and sell these puts to the MM at the bid, 5000 contracts for example. So now the MM has paid \$65,000 and is long 5000 of the June 15 $350 Puts, he delta-hedges respectively.
More and more traders keep coming in and selling this put and other puts around this strike. The MM over the course of the trading day continues to purchase a lot of winger options in his inventory and is long skew and convexity.
The bid-ask spread on this individual $350 strike put is only 1 cent. As are the majority of the bid-ask spreads on all deep OTM options (both calls and puts) on these short-dated SPY tenors.
We know that vol skew exists, and these deep OTM Options' implied vols are greatly overpriced most of the time. Buying them (while delta-hedging or not) will lead to losses as they expire worthless and never realize the volatility needed for a buyer who delta-hedges to even breakeven.
Say tomorrow $SPY realizes only 1% volatility, the MM will lose on his massive long skew/tails position of various different deep OTM put strikes on these weekly tenors.
My question is, how do MMs profit at all when they have to provide liquidity and purchase these short-dated deep OTM winger options that are quoted at high implied vols (skew) and majority of the time never end up realizing the vol needed for the MM to profit? With a 1 cent bid ask spread on these deep OTM options, how is there any room for the MM to buy below theo and profit off the spread?