The simple mechanics of “giving a market” are not difficult to learn. A market maker will have access to fair value sheets, which are printed daily, that list the BSM fair value of different options based on current market implied volatilities at different hypothet­ical futures prices. Fair-value sheets are printed daily or even intra-day by option software services (see Appendix) or by market makers themselves on private option software. A fair value sheet for calls will give information similar to that in Table 8.1, with the delta of the option listed in parentheses. In this example, the March expiration is 60 days away and the May 120 days, with implied volatilities at 15 for all options (a flat call skew).
If the futures price, for example, is trading at 100, then the March 100 call would have a fair value of 2.40 and the 105 call would be valued at 0.75, when market implied volatilities are at 15. By bidding somewhat below this value and offering somewhat above this value, a market maker gives his or her market. For example, a market maker might typically give “30, at 50” for a price quotation on the March 100 call when March futures are at 100, that is, 2.30 bid, offered at 2.50. If the futures price rose to 101 the market on the March 100 call would be “85, at 05," that is, 2.85 bid, offered at 3.05. (Generally, quotes are given in dollars end cents for h single option, as in $2.50 bid for the 100 call. The actual amount of the contract is always considerably more than this, of course, depending on the value of the the contract. Cents are sometimes referred to as “ticks” or “points” and dollars as “whole points,” although there is variation in each option market.)
 
Table 8.1 Hypothetical fair values for March and May calls

Futures Pricea	March			May
	100	105	100	105
101.00	2.95	1.00	3.90	1.85
100.50	2.65	.85	3.60	1.70
100.00	2.40(.50)b	.75(.22)	3.35(.50) 1.55(.30)

^aSee Table 5.3 for complete prices
^aValue of delta in parentheses
 
The width of the bid/offer spread is usually a function of the overall volume of options traded and the number of market makers competing. Generally, the larger the volume and the greater the number of market makers, the smaller the bid/offer spread. Also, within any specific pit, the bid/offer spread will usually be narrower in the front months and wider in the back months, which reflects the different costs of doing futures hedges in more or less active futures months. If a trade is completed at the market maker’s price, then the market maker will expect to earn the difference between the bid/offer price and fair value as profit.
If requested to do so by brokers, market makers may also give quotes by size for the amounts at bid and offer price, where one contract equals one “lot.” For example, if the market maker is 2.30 bid for 20 lots, with 50 lots offered at 2.50, the quote may be made as “2.30 at 2.50, 20 by 50.” If size is not quoted, a market maker is required to trade at least one lot at his quoted prices, but will usually be ready to trade much more than this to retain the interest (and respect) of brokers. If this transaction represented the total of all the skills needed to make a market in options, then computers could probably replace individuals in the pit completely However, giving a market on an option is only one (small) step in successful market making.
By now, one should understand from this text that the real skill of market making comes in maintaining the appropriate delta- neutral limited-risk option carryover positions. Without a risk- defined strategy the market maker will risk losing not only the liquid­ity function profit but also his or her entire capital. A market maker, therefore, must earn single trade profits, but do so within an overall risk-controlled strategy with adequate tactics. Previous chapters have discussed strategy, while this chapter considers tactics.
Having established a delta-neutral limited-risk position of some size, a market maker can give a market on both sides for all strikes for at least some quantity. This allows the market maker to earn a liquidity function profit without being too concerned over the short term about market price or volatility direction.
Nevertheless, the accumulation of market-making trades will mean at some point that the total position must be readjusted to maintain the original or desired optimum carryover position. A short straddle cannot be sold in quantity or continually without at some point becoming exposed to too much kappa/vega risk. Some form of spread trading or wing adjustment must be made. Also, asset or futures price movements will mean that the delta neutrality of most option positions will be changing to positive or negative and must be readjusted to neutrality. Thus, a market maker will be looking to make frequent delta or kappa/vega risk adjustments to the carryover position. The easiest way to do this is an option spread.
 
MAKING A SPREAD MARKET
In initiating a position from the start and attempting to main­tain one of the limited-risk positions on carryover, one must always begin by buying options and being long some volatility. This statement is self-evident in the case of the long straddle (which a trader only buys), but is also true for the separate initiation of a long butterfly or wrangle position. The long butterfly or long wrangle is always initiated by buying the straddle/strangle first, before selling a strangle/straddle against it.
Generally, these are the axioms that a prudent option trader will always follow: Go long before going short, and always remain net long more options than those short. A market maker should only sell what ho or she already owns or is risk-hedged against.
Short options need not he hedged only with other options, of course. Futures contract* are often used as delta hedgoH against option positions. But from the standpoint of catastrophic risk, delta hedging is inadequate and will fail over the long run if it is used exclusively against short positions. The basis of all successful risk hedging is both delta and kappa/vega hedging. Since the only way to hedge an option’s kappa/vega is with another option, all effective risk hedging must involve option spread trading. Having achieved a comfortable equilibrium with a limited-risk position, a trader will always be looking to do more spread trades, either outright, or separately.
The first things a market maker will look for in the pit at the opening of trading are (1) the prices at which options are trading and (2) the options that have changed from the implied volatil­ity settlements of the previous day. This information will indicate whether the market maker’s own fair-value sheets, based on the settlements of the previous day, need to be adjusted up or down before giving markets. This analysis need not involve printing new sheets (which would be inconvenient after trading has started); simply raising or lowering bids or offers to the appropriate implied volatility level is appropriate. As an added convenience, some fair-value software will even print fair-value sheets with multiple levels of fair values for different implied levels.
After the initial spurt of market orders and limit orders has traded, there will often exist declared broker orders that did not trade. These are then publicly posted on the option board. Boards are typically computer or electronic screens either on the exchange floor or on off-floor terminals. A typical option board might look like Table 8.2 after the opening call. This board indicates a broker’s order of 2.65 bid and a market-maker or broker offer of 2.95 on the 100 call. If the futures price remains trading at 100 then the 2.65 bid is above the 2.40 fair value of the call (from Table 8.1) when implieds are at 15. In fact, the 2.65 broker bid represents a 15 implied if futures prices were trading at 100.50, not 100. The market-maker offer, however, is made at a hypothetical futures price of 101, an even higher implied volatility than the broker bid. Temporarily, the market is bidding for a higher implied volatility than settlement volatility on the 100 call without finding any market makers willing to sell.
Table 8.2 Option board

	March
95 call
100 call	2.65B	2.95B
105 call		0.80B

 
In this situation, a market maker may make an even higher offer, say 2.95, if he or she is a reluctant seller. If this offer is not taken by the broker, a market maker will typically next look to see what orders have been publicly declared to the pit by current brokers in other strikes. Suppose, for example, that an offer exists of some quantity of the 105 calls at .80, that is, five ticks over current fair-value price of 0.75. This offer may be a broker order posted on the board, or a verbal pit offer from another trader or broker that has not been posted. A market maker will always want to know the size of the offer, for this information is useful in knowing how much to trade against it in a spread. Unfortunately, brokers will not always divulge the size of an order, and estimates must sometimes be made.
If the offer of the 105 calls at 0.80 appears firm for 10 lots or more, the market maker can look to make a spread trade in March calls by separately lifting or buying the 105 call offer and hitting or selling the broker bid of 2.65 on the 100 calls if there appears to be enough profit in the spread trade.
To calculate the potential profitability of the spread trade, a market maker will determine the fair value of the 100-105 March call spread from the fair-value sheets, (Table 8.1), or 2.40 - 0.75 = 1.65, when futures prices are trading at 100 and market implied volatility is 15. Since futures prices are hypothetically trading at 100, the only uncertainty is whether market implieds are likely to remain at 15.
Usually a market maker will have some idea whether the high broker bid on the 100 call represents a permanent shift in market implied volatility levels or is just a temporary high bid that will likely be soon hit. Let us assume the market maker believes the market level of implieds is likely to remain at 15 once the 100 call bid has been removed. Therefore, the 100-105 March call spread has a reasonable fair value at 1.65.
A typical reaction to the above situation, once these determina­tions have been made, is for a market maker to raise his or her bid on the 105 call from 0,70 (five under fair value) to 0,75 (fair value) to see if this bid will be hit by the trader or broker with the 105 calls to sell. If he or she can buy the 105 calls at 0.75 (fair value), then he or she can immediately sell an equal quantity of the 100 calls at 2.65, thus selling the 100-105 call spread for a total of
This will represent selling the 100-105 call spread for 25 ticks over the fair value of the spread, that is, 1.90 - 1.65 = 0.25. This spread will even be good if the market maker must pay the offered 0.80 for the 105 call, since the spread will be sold for 1.85 versus the 1.65 fair value. In fact, if the implied spread levels remained constant, a market maker may pay up to 0.95 for the 105 call and still make a small profit selling the 100 call at 2.65.
Depending on the quantities involved on each leg of the spread, some delta adjustment must then be made. If each leg traded only 10 lots, then the market maker will need to buy about three futures contracts to compensate for the larger amount of delta sold on the 100 calls than bought on the 105 calls [(10 X -.50) - (10 X .22) = -2.801. If the market maker had bought twenty-three 105 calls and sold ten 100 calls (going long the ratio spread), no delta adjustment with futures would be necessary.
If the market maker had sold the 100 calls outright at 2.65 and the implied volatility levels had remained at 15, he or she would also have earned 25 ticks outright. The trader’s delta neutrality would be maintained by going long one future for every two at-the-money 100 calls sold short. But although the theoretical profit would be the same for selling the calls outright or selling the spread, the former trade is only delta neutral, while the spread trade is both delta and kappa/vega neutral. Thus, the spread trade is vastly superior in terms of risk assumed.
Even if the settlement implied volatility has increased from that of the market-maker fair-value sheets, this spread trade will usually retain a net profit, although not so large. For example, assume that the market implied volatility increases over the market maker fair-value sheets and that the 100 call settles at 2.65 when futures prices are 100. In this case, the market maker has made no profit in selling the 100 calls at 2.65. However, by buying the 105 calls at 0.75 (the old fair value) the market maker now has a profit on this leg of the spread, for the increase in implied volatilities will raise the fair value of the out-of-the-money calls also (perhaps to 0.80 or 0.85). Even if the 100-105 call spread is now trading at a higher fair value than 1.65 (say 1.80), the market maker still will earn some profit by selling the spread at 1.90. Thus, by spread trading rather than selling calls outright, the market maker has protected himself or herself against kappa/vega risk, and has maintained the equilibrium of the basic carryover position.
Many traders think of spread trading in terms of the under­lying implied levels, that is, buying 15 implieds on one leg and selling 15.5 on the other leg. In some option markets option prices may be given in terms of implied levels, (for example, 15 implied bid, offered at 15.3) instead of actual prices.
In general, once a spread trade is established or anticipated, a market maker has some power to lean into bids or lower offers in the different strikes, trade over or under fair value, and still expect to make a profit on the spread. Exactly how much over or under depends upon some assumptions concerning the implied volatility skew within the spread itself. The topic of skew will be taken up again in a following section.
Making a market with limited-risk spread tactics is somewhat like learning the steps in a dance, the left and right of hedged spread trading. It is seeing the different possibilities in price spreads that always exist in the pit and taking advantage of them. Good market making is seeing and trading spreads before they become obvious to other traders.
 
MAKING A TIME SPREAD MARKET
Consider the time spread prices for March and May calls in Table 8.1. Let us now assume that there exist a broker bid for the 95 March calls that is posted for 5.80, and a broker offer of the May 105 calls at 1.55 (see Table 8.3). If there is no current time basis spread between the March and May futures (that is, March and May trade at parity to each other), then the 95 March call bid is 15 ticks over fair value and the 105 May is offered at fair value.
Table 8.3 March/May call quote board
Calls              March                  May
95                 5.80 bid
100
105                                    1.55 asked
At these prices, it is not yet possible to do a limited-risk option spread between the 95 March and the 105 May calls (the 95-105 March/May call spread). Although there is a hypothetical profit of 15 ticks in buying the 105 May calls and selling the 95 March calls (buying the spread), the spread is a calendar spread and, therefore, needs to be hedged for time risk. Although the March/May futures basis spread is zero, there is no guarantee that this will remain so. Therefore, the trader of the March/May call spread will need to make an adjustment in delta in the absence of other option trading. The buyer of March/May will have to buy March and sell May futures to make delta more neutral with respect to time for buying May and selling March calls.
An option market maker usually gives up the edge in trading futures spreads, and futures spread markets are sometimes much wider than markets in single months. For these reasons, a market maker must lose some portion of his or her profit on the March/May call spread to trading the futures spread hedge. The original 0.15 gross profit on the call spread must be reduced to only 0.10 or 0.05 after futures trading adjustment has been made.
In Chapter 7 we considered the argument that delta adjustment on a time option spread adjusts for delta neutrality but not volatility neutrality. The buyer of March/May option spreads will be exposed to unlimited risk in the March/May volatility spread. If the short option month implied volatility levels increase dramatically over the long month implied levels, then the buyer of the March/May option spread will be exposed to potentially un­limited loss, which periodically happens to large buyers of option time spreads. Thus, in order to earn a 0.05-0.10 profit on a time spread option trade, a market maker would be exposed to catastrophic risk if he or she adjusted for time only with futures contracts.
The only secure option time spread cannot be completed at the prices in Table 8.3. A market maker would look to complete March/May spreads separately (by buying other March calls against the short 95 March calls or selling other May calls to buy the 105 May offer), or to trade the March/May spread in some other way.
Brokers sometimes bid or ask for option time spreads that offer astute market makers opportunities for profit. Let us assume as before that there exist a 5.80 bid for the 95 March call and a 1.55 offer for the 105 May call, with both futures remaining at 100. Now, suppose a broker bids 1.10 for the March/May 100 call spread, that is, offers to buy the May call 1.10 points over the sale of the March call. Can a market maker trade profitably at these prices?
To determine whether this is a good trade, a trader will con­sider that the fair value of the March/May 100 call spread is .95 May over March (3.35 - 2.40). By offering to pay up to 1.10 May over March, the broker is bidding 15 ticks over the fair value of the option time spread. As with the the March/May 95-105 call spread above, there is no advantage in doing the March/May 100 call spread alone because of the reduced profit after time spread and futures delta hedging costs have been subtracted and because of the unlimited risk exposure.
However, by trading the March/May 100 and 95-105 call spreads together at the above prices, a market maker can earn a good profit and assume no unlimited time risk. A good market maker will sell the May 100 calls (at 3.50) and buy the March 100 calls (at 2.40) for a time spread of 1.10, and simultaneously buy the 105 May calls and sell the 95 March calls that are posted. The completed trades will look like this:
Sell March 95 calls at 5.80 (15 ticks over fair value)
Buy March 100 calls at 2.40 (fair value)
Sell May 100 calls at 3.50 (15 ticks over fair value)
Buy May 105 calls at 1.55 (fair value)
The gross profit on these trades is 0.30, assuming a one-to-one ratio of purchases to sales. Since the spread trades are completed as noncalendar spreads, no futures time spread adjustment is required, although some futures adjustment may still be necessary in each month separately. In this example, a trader would most likely have to buy both March and May futures in some small amounts to remain delta neutral, unless he or she traded some ratio spreads. Thus, the gross profit of .30 will be little dimin­ished. In executing these trades a market maker has completed two separate noncalendar spreads that need minimal time spread delta or kappa/vega adjustments.
These kinds of spread opportunities are what a market maker must look out for. A novice option trader may wish to practice calculating option spreads in his or her head until it becomes Hocond nature. AIho, trad«rM will find it advantageous to remember broker spread orders that did not get filled immediately; they usually are not posted although they may remain current. With a sudden market move, these broker spreads may become tradable for a spread scalper.
Unfortunately, much of the time it is not possible to do simultaneous offsetting time spread trades, or even vertical spreads, without legging them. Legging spreads has a limited risk in normal volatility periods only if the long side is put on first, then the short side.
There are traders who do attempt to leg spreads by going short first. To the greater risk goes the greater profit—but also the greater (potential) loss. Trading in this way will sooner or later produce financial catastrophe. Legging spreads as well as putting on any new position is best done by going long, then short in a leapfrog sort of way.
How long to go on the first leg? This is a subjective judgment; 20 lots is large to some, small to others. An option trader will want to avoid too large a time decay on the first leg of a time spread, but here again what is large to one is not to another. Some traders will always do a size of 100 or more, even in a narrowly liquid option pit.
Some tactical issues facing spread traders have been discussed in the last two sections. Good option market making is essentially good vertical and time spread trading.
 
POSITION DELTA ADJUSTMENTS
If the delta-neutral limited-risk strategy has proved successful, a trader is confronted with maintaining the delta-neutrality and limited risk of nonsynthetic positions. To stay delta-neutral, the trader usually must make small continual adjustments in the option carryover position and any new trades. A change in futures prices almost invariably changes an option’s delta, and this will throw the position off delta neutrality, requiring some adjustment to be made eventually. If the trader is long two at-the-money 100 calls and short one future, the trader will be delta-neutral. When futures move to 110, however, the trader will now be net long delta, for example.
But position delta can change even if futures prices do not. There is some tendency for the net delta of an option position to shift over time, gradually in the back months and more abruptly in the front months. A change in the implied volatilities of an option will also usually change an option’s delta. There are several reasons for this delta drift.
First, the passage of time means that the standard deviation will shrink, all else being equal. A smaller standard deviation will also shrink the delta value for an out-of-the-money option and increase the delta for an in-the-money option (while the at-the-money option will always remain at .50).
For example, a long 100-110 vertical call spread that has a net delta of about .30 in the back months when futures are at 100 will increase to about .40-45 delta in the front months if volatility remains constant and futures remain at 100. The long 100 call will retain +.50 delta but the negative delta of the 110 call will shrink over time; thus the total delta of the call spread will assymptotically approach +.50. For small option positions, this daily delta drift is negligible, but for large positions delta drift may mean that a market maker’s carryover position is going long or short several futures contracts with the passage of every day.
Second, the delta of an option position will also be affected by changes in the implied volatility levels. Intuitively, one expects that the out-of-the-money or the in-the-money option time premium will be affected by how likely it is that the option will end in-the-money. A higher implied or real volatility level will increase the likelihood of expiring in-the-money and, all else being equal, will affect the delta of the option. An increase in implied volatility will increase the delta of an out-of-the-money option and decrease the delta of an in-the-money option.
In summary, the passage of time and changes in the implied volatility levels will affect the total position delta. This position delta change is termed delta drift. In general, the total net delta of a vertical spread will more nearly resemble the delta of the near- or at-the-money strike option closer to expiration and the lower the implied volatility level. The occurrence of delta drift requires some adjustment trading on a periodic or even a daily basis in order to maintain delta-neutrality.
To keep track of required position delta adjustments, an option trader must know what his or her position delta is at all times, and what it would be under different changing market conditions. To track delta, one usually uses position analysis software, since market-maker carryover positions may grow so large that they are not easily analyzed by manual calculation. With software, however, it is easy to track position delta under different time and volatility assumptions and identify what adjustments must be made. Because of time spread risk, it is important to analyze position delta on a single calendar month separately—that is, without time spreads included.
A position delta analysis for a hypothetical option position under different market price, volatility and time assumptions is shown in Table 8.4. With futures at 100 and implied volatility at 15 on the current day, the net position delta is neutral (as indicated by *). However, position delta will change as futures prices move up (position delta long 10 at 104) or down (-10 at 96). Position delta will also often change for large positions if there is a shift in the level of market implied volatilities (a +1.00 shift in delta for a + 1.00-unit shift in implied volatility level). Finally, in the example the passage of one day will lower the net position delta by one, all else being equal. A delta drift, or changes in any one of these factors (futures, implieds, or time), will often necessitate some trade adjustment if delta neutrality is to be maintained on the carryover position.
Of course, during the day a market maker will be doing additional trades that affect position delta. Market makers routinely keep a cumulative net delta tally of trades during the day. When it is added to the net delta of the carryover position, a trader should know to a close approximation his or her total net position delta without continually entering all trades into the computer right when they occur. A midday exact update would be prudent in busy trading, though.
Table 8.4 Position delta

	Implied Volatility Levels
	Current	Day	Next	Day
Futures Prices	15	16	15	16
104	10	11	9	10
102	5	6	4	5
100	0*	1	-1	0
98	-5	-4	-6	-5
96	-10	-9	-11	-10

gamma =+2.5.
*Net position delta is neutral.
Combining the information from the carryover position delta based on futures prices and implied levels with the net delta of the daily trades, a market maker will strive for delta neu­trality. At this point the tactics of adjustment diverge, depending upon whether the carryover position is net long or short gamma/kappa/vega/theta. These will be discussed over the next several sections.
 
GAMMA TRADING
Any non-synthetic option position will have either a negative or a positive gamma risk exposure. In Chapter 4 we found that negative gamma in single-month positions is always associated with negative kappa/vega and positive theta. Positive gamma is always asso­ciated with positive kappa/vega and negative theta. Since gamma represents the change in net delta for a fixed change in asset price, gamma trading is concerned with adjusting net delta after an as­set price change has occurred. A positive or negative gamma stance will require different adjustment tactics, discussed below.
The only delta-neutral limited-risk strategy that is partially negative gamma is the long butterfly. Keeping a butterfly strictly at delta neutrality at all times is very difficult since using futures to adjust large butterflies will alter the structure of the butterfly itself. Unless balanced by one-to-one spread trades, a butterfly will quickly become either a catastrophic risk position if too many options are sold or a long ratio spread or wrangle if too many are bought. As a practical matter, therefore, a trader who makes markets on a strict butterfly carryover is rare. Nevertheless, these guidelines for delta adjustment of the long butterfly will serve generally for near-butterflies or other partially negative gamma/kappa/vega, positive theta positions.
The adjustment tactic for any negative gamma strategy if futures prices are rising and a negative delta is accumulating is to buy calls, sell puts, or buy futures. Each of these trade actions will add positive delta to the carryover position. If the market is falling and a positive delta is accumulating, the trader will look to buy puts, sell calls, or sell futures, thereby adding negative delta to the carryover position. Negative gamma tactics trade with the trend to adjust delta.
Using futures contracts to maintain delta neutrality is probably the least desirable. Aside from (usually) losing the edge in the futures pit, outright futures positions expose the trader to the possibility of frequent whipsaw losses during the day and can be very frustrating to trade. Short gamma traders are usually the ones to buy the high and sell the low of the day’s futures prices. Yet, not adjusting will at times incur even greater losses, and futures are often the first means of delta adjustment in the market.
A better way to adjust delta is to use options rather than futures, and get the edge doing so. However, a trader will not always be presented with the opportunity to buy puts directly in a falling market with the edge, or to buy calls in rising markets in positive theta ranges.
Presumably, in falling markets the demand for puts means that a market maker will be pressed to sell puts rather than be afforded the opportunity to buy them. Likewise in rising markets, market makers may be asked to sell calls rather than be allowed the opportunity to buy them. Of course, if it is not possible to buy puts in a falling market or buy calls in a rising market with the edge, it will also not be possible to sell futures synthetically (buy the put, sell the call) in falling markets or buy futures synthetically (buy the call, sell the put) in a rising market.
The most favorable delta adjustment in trending markets occurs when puts or calls are mispriced with respect to each other, and it is possible to buy (or sell) the cheaper (or more expensive) and turn it into an opposite put or call synthetically. In falling markets puts may be overpriced and calls underpriced at fair val­ues to each other, and in rising markets calls may trade over the fair value of puts.
Thus, in a falling market it is often possible to buy calls cheaply, as others rush to sell, and, by selling futures contracts simultaneously, to buy a long put synthetically. Likewise, by buying undervalued puts on the upside and as well as a futures contract, the trader has bought a long call synthetically that is often cheaper than the actual call. In this way a market maker can maintain delta neutrality and at the same time earn a reasonable profit with the edge.
How much delta adjustment should a trader in a negative gamma position make over small future price changes? There is probably no way to answer this question with complete certainty. The size of gamma is the measure of the risk the trader takes by not adjusting delta. The appropriate size of gamma risk cannot be predetermined for every position, but depends in part on the size of the trader’s capital and on the trader’s ability to sustain an occasional series of small and sometimes large losses. An unlimited-risk negative gamma trader, however, unlike a positive gamma trader, will eventually be forced to adjust position delta to avoid extremely large or catastrophic losses.
One thing a short gamma trader should not do as a delta adjustment is to sell only options, whether puts or calls. Selling options only will increase the negative gamma and expose the trader to increasing catastrophic risk.
As a matter of course, positive gamma/kappa/vega, negative theta strategies (also known as long premium strategies) will face situations in which, as futures prices rise, the position becomes increasingly long delta; and, as prices fall, increasingly short delta. To remain delta neutral on the upside, a trader will sell futures, buy puts, or sell calls, which will add negative position delta. Likewise, on the downside the trader will buy futures, sell puts, or buy calls to add positive delta. Since the long gamma trader will be selling calls and buying puts in a rising market and selling puts and buying calls in a falling market, the astute market maker can also earn an extra profit if the same strike put/call market is trading at a premium/discount relationship. In any case, these adjustments may be used to re-establish delta neutrality.
Sometimes the long gamma trader can let the delta run in one direction or the other, following the trend of the market. If a market maker does not adjust to delta neutrality and the market continues to run further in one direction, the profits to the long gamma trader may become considerable. For this reason a trader who is long gamma may not always wish to adjust to delta neutrality as a tactic, unlike the negative gamma trader. This flexibility in delta adjustment, open to the long gamma trader, is referred to as gamma trading.
For example, assume that a long gamma trader is initially delta neutral, but during the day the futures prices stage a big rally. This rally increases the net position delta from neutrality to +5 delta points and the trader, in effect, is long the equivalent of five futures contracts. The long gamma trader has a paper profit from the rally in futures prices.
The question of whether to lock in this profit or to let it run must be faced by any long gmnmn trader. On the one hand, by letting delta continue to run in the direction of futures prices without adjustment, a trader may accumulate very large profits if futures prices move in one direction or another in a big move. On the other hand, if the trader does not lock in the profit (by sell­ing five futures contracts), and the rally fails and futures prices move back to where they began, then the trader will show no profit from this temporary gyration in the market. If the trader had sold the five futures to lock in the profit, the decline in futures prices would not affect this profit since when futures prices had finished retracing themselves, the short futures would be covered and the long gamma position restored to its original condition.
In choppy markets, gamma trading comes into its own. By adjusting delta frequently during the course of a wildly gyrating market, a long gamma trader may make very large profits, even if futures prices settle unchanged for the day. Getting whipsawed is no problem for the long gamma trader, who will often be selling at the top and buying at the bottom.
There is no exact answer to the question of when to readjust to delta neutrality in the event of a futures price move. Small positive gamma positions may require little or no delta adjustment for many trading days as prices remain in narrow ranges. In the event of a large price move, however, adjustment becomes more pressing.
What constitutes a large enough price move to adjust delta? There can be no definitive or absolute answer. It depends as much upon a trader’s style as anything else. At some point in an extreme daily price move, it is probably wise for long kappa/vega traders to lock in some profit by delta neutralization and secure the profits already made. In wildly active markets that are going up and down, gamma trading these whipsaws can be very prof­itable.
Of course, limit move days must be considered the best outcome for long gamma strategies, since the market moves furthest and little delta adjustment may be possible or needed as profits accumulate. Perhaps once every five to ten years, most commodities will experience a truly phenomenal move, with limit days in one direction strung together in a run. Although only exposed to limited risk, a long gamma trader at these times may earn spectacular returns, as discussed in the section of Chapter 7 dealing with trading high volatility.
 
ADJUSTMENT OF THETA ()/KAPPA (K)/VEGA
In addition to delta and gamma adjustment, large option positions usually require ongoing theta and kappa/vega risk adjustment. As noted in Chapter 3, these risks are related. Single-month option positions that are positive kappa/vega are always negative theta, and negative kappa/vega positions are always positive theta. Also, the absolute sizes of kappa/vega and theta risk are linked over time. Kappa/vega risk is greatest furthest from expiration and least at expiration, whereas theta risk is always highest at ex­piration and least furthest from expiration. There is a time drift to kappa/vega and theta risks that may often require adjustment for this reason even if nothing else has changed.
Basic strategy calls for a limited-risk profile with respect to kappa/vega. Thus, aside from the butterfly position, market makers will tend to be positive kappa/vega and negative theta, that is, long volatility during normal volatility periods. The prudence of long volatility will be more valuable when expiration is furthest away and when kappa/vega risk is at its highest. Generally, back- and middle-month LRO-DN positions must pay more attention to kappa/vega, and near-front-month positions to theta. But any strategy is cautious about becoming too long kappa/vega, especially at high levels. A smart strategy seeks to avoid catastrophic risk at all times, to profit by real or implied volatility explosions, and to limit time decay loss.
But how much long kappa/vega risk is appropriate in back- month positions? The answer depends upon trader risk assumptions and will vary. A conservative rule of thumb is not to be long more kappa/vega than a trader could reduce to neutrality in one or two days. The number of options required to establish neutrality will generally increase over time as kappa/vega risk falls towards expiration. For example, a sale of 10 at-the-money options may move the kappa/vega risk of the entire position by $1,000 at 100 days to expiration, but the same sale will change the kappa/vega risk by only $500 at 50 days to expiration.
A very high positive kappa/vega risk for a long wrangle would resemble a long straddle, which has been seen to have some disadvantages. How large a kappa/vega risk in dollar or percentage terms will depend to some extent upon the size of the trader’s capital, the average volume in the pit, and a trader’s taste for at least some risk,
As back-month positions become front-month positions, the negative theta on long ratio spreads and long wrangles will become increasingly costly. At that time the trader should think of bring­ing the wrangle closer to a butterfly/condor. Exactly how much theta risk to carry in the front-month positions also depends upon trader assumptions about risk and market.
Maintaining a positive or neutral theta is perhaps one of the more difficult challenges an option trader faces near expiration because at that time the public is often a net seller of at-the-money options in many option markets. This same situation confronts stock option market makers, who also must take the long side of the public’s preference for covered call writing.
To maintain a positive or neutral theta in the center strikes, an option trader must buy as many contracts as he or she is selling. Option traders may want (1) to lower their bids slightly below fair value to avoid attempting to support sagging prices induced by net public selling close to expiration and (2) to avoid too much net buying. For traders positive kappa/vega closer to expiration, some net selling of options may be necessary on an ongoing basis to curtail the increasing loss due to time decay.
As with position delta analysis, position kappa/vega/theta analysis commonly relies on computer software. On such software a typical single-month position analysis might look like Table 8.5. This hypothetical position would be positive kappa/vega and neg­ative theta in the dollar amounts shown for a range of futures prices. For example, when futures are at 100, this position will profit $1,000 by a one-point increase in market implied levels but lose $300 per day on time decay. This position would present a bidirectional limited kappa/vega risk profile, which is consistent with basic prudent strategy.
Table 8.5 Position kappa/vega and theta: Example I

Futures Price ($)	Kappa	Theta
104	+2000	-500
102	+ 1000	-300
100	+ 1000	-300
98	+ 1000	-300
96	-I 2400	-700

 
 
A problem that may frequently develop for a market maker careless about strategy is a directional lopsided kappa/vega risk. That is, position kappa/vega risk changes sign with futures price change. Such a position might look like Table 8.6. This hypothetical position has a bimodal kappa/vega/theta risk profile; the down­side has limited kappa/vega risk, but the upside has unlimited risk. This position is characteristic of vertical spreads, fences, or cartwheel strategies, which have bimodal kappa/vega risk.
A bimodal kappa/vega risk position often may develop if a trader is doing too many fences with brokers, that is, selling calls and buying puts that are not of the same strike. Doing fences without separate adjustment of the put and call spread will lead a trader into a bimodal kappa/vega risk position eventually. When a bi-modal position becomes apparent, a trader will tactically try to buy options on the short kappa/vega wing until the problem is corrected. These purchases must be made as soon as possible, for the wing that is short kappa/vega also exposes the trader to catastrophic risk.
One way to obtain a rough idea of how much bimodal kappa/vega risk a position is carrying is to notice the net futures in the carryover position that are not part of synthetics. A large net-futures carryover that is not synthetically based is probably a lopsided kappa/vega risk position.
Of course, a trader will sometimes, through an inadvertent sale of options, become short kappa/vega on both wings. In a sense, a trader tips his or her own canoe and inverts the risk profile. This situation is even more serious than a bimodal kappa/vega risk position, since now the position is catastrophically risk exposed both on the upside and on the downside in futures prices. A short kappa/vega position can only be corrected by the purchase of puts or calls, straddles or strangles, which traders should do quickly to remain risk limited.
Table 8.6 Position kappa/vega and theta: Example II

Futures Price ($)	Kappa	Theta
104	-500	+ 500
102	-300	+ 200
100	0	0
98	+300	-200
96	+ 700	500

 
WATCHING THE IMPLIEDS
Among option traders there is great interest in knowing what direction implied volatility levels are headed. A market maker will always know where the current implied levels are, especially for the at-the-money straddle. But knowing where the implieds are does not identify where they are going. Knowing the direction of implied volatilities for an option trader is like knowing the direc­tion of price for a futures trader. There are several ways of following implied volatility trends.
Sometimes charts and moving averages of implied levels are used to give some idea of the future, or at least current, direction of implied volatility. Something simple will usually be sufficient to alert the market maker to the primary trend. Many exchanges regularly publish time charts on historical volatility as shown in previous chapters, and, of course, market makers will have the daily results of implied levels, which can be charted easily.
Option traders will also want to know any past seasonal variations in implied levels that are due to change of crop season or other factors. In many seasonal crop futures, real and implied volatility levels may be higher when carryover stocks are lowest, at the transition from old crop to new crop. Once the new har­vest is in, stocks are replenished and volatility may seasonally go down, which is the case in soybean implied volatilities noted by Christopher Bobin (1990). (See Figure 8.1.)
Whatever method of following implied volatility trends he or she uses, an option market maker is most likely first to know of an implied volatility change through daily trading on the floor. As noted in Chapter 7, following broker net order flows will give the trader some idea of the supply/demand for options and, therefore, the likely current trend and direction of implied levels.
If it becomes increasingly difficult for a trader to do both legs of an option spread, and if repeated failure to leg spreads is giving the total cnrryover position a lopsided kappa/vega (short or long) while awaiting the completion of the spread, then the side of the spread that the trader is having trouble completing indicates the next direction of implied levels. Some traders develop a keen pit sense of implied volatility change in this way through spread trading.

Figure 8.1 Average monthly soybean implied volatility, 1986-1988. (Source: Christopher A. Bobin, 1990, Agricultural Options: Trading, Risk, and Management, New York: John Wiley and Sons, Inc.)
 
SKEW RISK REVISITED
An option trader will always want to know where the at-the-money straddle is trading, both in dollars and as an implied volatility. The at-the-money straddle will set the center of the skew of market implied volatility. Skew is the difference between the at-the-money implied levels and the implied levels in the remaining strikes. There are two skews: a put skew and a call skew. Out-of-the-money options often trade at higher implied volatilities than at-the-money options; that is, there is a positive skew for both puts and calls. Since these skews need not remain constant, they represent skew risk to any vertical spread trade.
The degree of skew often appears to be directly related to different, option expiration cycles. That is, options that are the furthest to expiration (more than nix months) are likely to reflect fair values close to the BSM model over the lowest and highest strikes traded and, therefore, present a flat skew. Options in the middle range to expiration (from three to six months) have a saucer-shaped positive skew, and the near-term options (less than three months) begin to resemble a steep bowl-shaped positive skew over the lowest and highest strikes on the board (Figure 8.2).
Negative skew is generally rare during any expiration cycle for most options markets. The most important exception is stock and stock index options, where there is often a persistent negative call skew.
Market makers usually seek to replicate these implied skews (positive or negative), as identified from raw data, in printing fair- value sheets or in making markets practically. It can be shown, however, that the difference in time skews is, at least in part, more apparent than real. What the raw implied time skews do not take into account is the relative distance between strikes. The distance between a 100 and a 110 strike with a year to expiration is not the same as when there is only a month to expiration. The reason is that futures prices may easily move the distance between two wide strikes with lots of time, but be very unlikely to do so with little time remaining.
To compensate for time differences in implied skew, one can measure skew in a standardized vertical and horizontal scale.

Figure 8.2 Implied volatility skew, unstandardized.
Two modifications may be made. First, the raw implied levels may be recalculated by dividing the wing strike implied by the at- the-money implied levels. These calculations will give a series of skew BSM implied relative levels that may be used in place of the absolute levels. For example, if the implied of a 105 wing strike is 15.75 and the 100 center strike is 15, then the implied relative is 15.75/15 = 1.05. That is, the 105 strike carries a 1.05 BSM implied relative to the 100 strike.
Second, a more important modification is to standardize the horizontal scale of strikes. This may easily be accomplished by measuring strike distance between wings and the center in terms of standard deviations (SDs) of futures prices. For instance, with a 15 implied volatility, futures prices at 100, and 41 days to ex­piration, the SD will be just over five futures points. Thus, the 105 strike in this example will be just about one SD from the 100 strike. With only 10 days to expiration, however, with all other as­sumptions the same, the 105 strike will be about two SDs from the 100 strike.
When implied skews are measured in terms of standard deviations (SDs) along the vertical scale, much of the apparent differences between time skews disappears. To show this, consider a time option series in which the back months have an SD of 10, the middle months an SD of 5, and the front month an SD of 2.50. If the implied relatives are 1.05 at one SD and 1.15 at two SDs, then the empirical time differences of implied skew in Figure 8.2 will disappear. This fact may quickly be verified by noting that when the SD — 10, the 110 strike has an implied volatility of 15.75 (a 1.05 implied relative); when the SD = 5, the 105 strike also has an implied of 15.75, and so on. Despite the diversity of different time implied skews, all skews when standardized are taken from only one adjusted skew model. Variations in empirical cycle skews will greatly diminish after one has adjusted for time and standard deviation, as illustrated in Figure 8.3.
Even though standardization reduces empirical skew risk, it is not eliminated entirely. The existence of a standardized implied volatility skew presents a theoretical problem to the BSM fair-value model. The market seems consistently to overprice out- of-the-money options relative to at-the-money options. Essentially, market participants evaluate options from a probability standpoint unlike that used by the RSM model; traders seem to assign greater risk to more extreme futures price moves than the normal curve suggests. In the jargon of statistical theory, the empirical distribution has thicker tails than normal and is platykurtic.

 
Figure 8.3 Standardized implied volatility skew.
 
There has been much interest in developing alternative sta­tistical models of futures price change that do not depend on the normal curve. These can be used to produce other fair-value option models than the BSM model, with binomial or more complex interest rate structures as discussed in Chapter 2. In the optimum outcome some alternative fair-value models could eliminate some of the existing implied skew from the BSM model and possibly eliminate the data-normal error curve itself.
In a perfect option model, there would be no standardized implied skew at all, but it is unlikely that such perfection will be achieved, even in the best-constructed alternative models. Recognition of this improbability arises because the time-adjusted empirical BSM skew itself is not constant over time but wobbles, with implied relative volatilities rising or falling with no corresponding change in futures standard deviation. Despite standardization, there is instability in the skew implied relatives. Sometimes the wings trade at a greater standardized implied relative to the cen­ter than at other times (all else being equal). Thus, at 1 SD the implied relative may be 1.05 on one day but at 1.07 the next, without the at-the-money implied levels having changed.
Wobble in skew poses an investment risk to any vertical spread trader. Large market-maker carryover positions are particularly subject to wobble risk insofar as they are composed of many spread positions. Since a spread is always the trade of two different strike options, skew will always be an important factor in evaluating the fair-value of the spread. Wobble in skew translates into wobble in spread fair-values, which may cause serious financial conse­quences for large spread traders.
Consider the fair-value of a 100-105 call spread, with 60 days to expiration, an interest rate of 7 percent, a futures price of 100, and an implied volatility for the 100 call at constant 15 with the 100 call valued at 2.40. At an implied volatility of 15 (flat skew) the 105 call has a fair-value of 0.74; at an implied volatility of 16 (low positive skew) the 105 call has a fair-value of 0.86, and at an implied volatility of 17 (high positive skew) the 105 call is worth
0.98.
The fair-values of the 100-105 (lxl and 1x2) call spreads under these different skews are found in Table 8.7. If a trader were to buy the 100-105 (lxl) call spread (buy the 100, sell the 105 calls) when skew was flat at 1.66, then a loss could accrue if the skew went from flat to low or high positive skew ($1.54 - $1.66 = -0.12 and $1.42 - $1.66 = -0.24). If the trader were to short the ratio spread by buying the the 100 call and selling the 105 call twice (1x2), the results financially would be even worse as skew moves from flat to low to high positive (0.68 - 0.92 = -0.24 and 0.44 - 0.92 = -0.48).
From the standpoint of skew risk, it is not a good idea to be a buyer of bullish call or bearish put spreads when skew is flat, or to attempt to short the ratio spread. Rather, selling option (lxl) spreads and going long the ratio spreads during flat skew periods is a better strategy. During periods of high positive skew relatives, it is better to buy option spreads and cover any short spreads or long ratio spreads. A long wrangle will experience a profit going from a flat to a high skew but a loss going from high to flat skew.
For large traders (with many hundreds or thousands of contracts and spreads), a skew wobble in the implied relatives can translate into thousands of dollars of fluctuations in an option account balance on a daily basis. Spread positions will experience wobble fluctuations in daily profit and loss accounts. Failure to take into account wobble can mean a market maker taking on spread trades that will later prove overpriced even when there is no change in the at-the-money implied volatility or futures prices!
Table 8.7 100-105 Call spread values by skew

	Spread (dollar value)
Skew	(1X1)	(1X2)
Flat	1.66	.92
Low positive	1.54	.68
High positive	1.42	.44

(See Table 5.3 for underlying option prices.)
 
The best way for a market maker to ensure that this does not happen is to be aware of the ranges for skew relatives on the particular option contract in which he or she is making a market and attempt to spread trade accordingly. A trader would try not to pay more for wing options than flat or low skew prices, and would at­tempt to sell or liquidate positions during high skew prices, all else being equal.
A further difficulty in skew risk is that the center strikes of the skew will change in a large asset or futures price move, thus moving or shifting the entire skew itself, as in Figure 8.4.
A shift in skew may significantly affect the value of vertical spreads and is a risk to the complex spread trader. For example, if a trader executed a short 100 strike and a long 110 strike call spread when skew is centered at 100 strike then a futures/asset price move to 110 will shift the entire skew so that the short call is now at the high point on skew and the 110 call will be at the center strike. In effect, even though skew remained positive after the shift, the call spread would have suffered the same financial effects as if skew had gone from positive to negative!
The effects of skew wobble occurring simultaneously with skew shift may be additive and present some significant risk to any complex option vertical spread trader. Moreover, there is no perfect way to hedge complex vertical spreads against skew wobble and shift risk, short of synthetic trading. Nevertheless, although it is an important risk, skew risk is not unlimited, fortunately. In the end, market judgment and cautious experience may be the best guides.

Figure 8.4 Skew shift resulting from a large asset or futures price move upward.
 
TRACKING TRADING RESULTS
A market maker will usually be able to tell whether he or she is trading successfully by whether he or she is making a profit over the long run. Clearinghouses will provide a trader with a daily net account balance that gives the final tally. It is useful, however, for a market maker to keep his or her own financial accounts, independent of clearinghouse records. There are several reasons for doing this.
First, keeping independent accounts can be used to verify clearinghouse records. Although intentional mistakes are rare, clearinghouse records often show clerical errors, sometimes of a large magnitude. Without an independent account record, a trader is sometimes helpless to correct clearinghouse statements. If the clearinghouse statement remains uncorrected, which sometimes happens, a trader may incur a large windfall loss.
Second, without an independent account to highlight clearinghouse account inaccuracies, a trader will not know his or her exact position and cannot adjust properly or know the risks he or she is under. There will always be traders on any exchange who do not know their exact position because of clearinghouse confusion, and who then take a large hit, sometimes even being wiped out.
Third, keeping an independent account gives the trader the ability to track and analyze trading results. Although one might assume that overall profitability is an indication of market-making success, this need hardly be the case. Market-maker profitability must be distinguished from overall profitability if a market maker wishes to assess accurately his or her own trading success (or loss).
For accounting purposes, total profit/loss (P/L) may be divided into that P/L resulting from the carryover position, and that P/L from daily trades. To show the daily P/L for the carryover position, mark the value of the position to settlement prices at end of Day 1 and Day 2 without adding new trades, and take the difference. This will represent the P/L due to the carryover position over one day. To show the daily P/L due to new trading, subtract the prices of the option at trade from the settlement prices for that day. The daily P/L due to the carryover position when added to the daily trade P/L will equal the total P/L of the position.
The net daily carryover P/L corresponds to the P/L of the limited-risk strategy itself, while the daily trade P/L will show the results due to market making. A market-maker will be trad­ing successfully if the market-making profits are a large or the largest share of total profits over the long run.
Consider the P/L separately for the daily carryover account and the daily trading account, as in Table 8.8. The total profit for the combined carryover and day trades in Table 8.8 is +1, but this is entirely contributed by the day trade results. To do the next day, the net day trades by strike and option are added to or subtracted from the carryover position, and a new carryover position is established for the next day carryover position accounting, plus whatever next day trading occurs.
 
 
Table 8.8 Example of total profit/loss statement for a hypothetical market maker

Daily Carryover Account
Carryover and Prices	Settlement Day 1		Settlement Day 2	End Day 2 Profit / Loss
100 short 100 calls	2.00		2.10	-10.
100 long 100 puts	1.00		.90	-10.
Long 100 futures	.80		1.00	+20.
Subtotal profit				+ 20. -20.
Total carryover profit				zero
Daily Trading Account
Day Trades and Prices	Day 2 Trade Price	Settlement Day 2		End Day 2 Profit /Loss
Sell 10, 100 calls	2.20	2.10		+ 1
Buy 10 futures	100	100		zero
Subtotal profit				+ 1
Day trading profit				+ 1
Net Profits by Activity
Carryover position				zero
Day trades				+ 1
Total not profit				+ 1

 
A trader may wish to refine the analysis of P/L for the carryover position further by doing each cycle separately. With an ongoing daily record of this accounting, a more detailed P/L record is visible. For example, consider the daily P/L accounts in Table 8.9. In this Table, the net result of the May, July, and December positions is -$100 ($0 - 150 + 50), largely stemming from the poor July cycle results. This result is not necessarily too serious since many monthly position P/Ls will show short-term deviations that balance out over time. A trader would, of course, want to examine the larger July loss in this example to see whether it represents a poorly hedged position or just reflects daily irregularities in set­tlements, which quickly adjust themselves.
In Table 8.9, the net result of the carryover positions was -$100, but profits from daily scalping were $300, giving a total net profit of $200. With daily market making contributing a large share of gross and net profits, one may infer that this trader is market making successfully but might be able to improve results by adjusting the carryover position.
The accounting assumption that day trade net results are attributable to market making over the long run is probably valid. Although the daily net trading profits may also be attributable to gamma adjustment tactics, over the long run these daily gamma adjustments should net to zero against daily carryover position changes, leaving the remainder of the daily P/L as net market- making profits. Thus, it remains true that a positive net P/L total over the long run on the daily trading account is an approximate indication of market-making profitability if a trader has remained delta neutral in the carryover position.
Table 8.9 Daily P/L by component

Carryovers ($)
Day	May	July	December	Day Trading Net ($)	Net Total ($)
1	100	-200	+300	+50	+50
2	+100	+100	-200	+250	+250
3	0	-50	-50	0	-100
Total	0	-150	+50	+300	+200

 
If over a longer period a trader’s total profits are largely con­tributed by day trade results, then a market maker is trading well. If this is not the case, or the trader is losing money on net balance, then looking at the accounting results separately by day trade and carryover position will help diagnose the problem by indicating where loss is occurring.
 
COMMON MISTAKES
Mistakes are inevitable. Since market makers and scalpers work for a small arbitrage profit, however, even small mistakes can mean the difference between profit and loss. Although mistakes are in­evitable, they should be minimized as much as possible.
What are the most frequent mistakes option traders make? There are at least four areas in which traders probably err re­peatedly. These are:
1     Failure to hedge delta
2     Incorrect delta hedging
3     Overtrading
4     Poor kappa/vega risk adjustment
 
Failure to Hedge Delta (△)
Not maintaining delta neutrality is probably the single most frequent mistake an option scalper will make. The best type of option scalping is spread trading, but when this is not immediately available an option trader must hedge delta to remain delta neutral. Many traders, however, do not immediately execute delta adjustments in the futures market after doing a nonspread option trade. This is a mistake. Thking a shot is, in fact, speculation, and market makers who do not hedge their delta risk immediately are speculating.
The lure to speculate by not futures hedging one’s option trades immediately is strong. By attempting to get the edge on the futures side, a market maker can often double the profit of the trade. This will happen just often enough to yield positive reinforcement for the trader to continue to avoid immediately hedging futures.
In the instances in which the trader does not get the edge, and does not get his or her futures hedge off, the market may (and probably will) move against the trader on the unhedged option side, causing losses instead of profits. If an option trader were willing to accept a loss immediately, the losses and profits would probably balance out to neutral in the long run, perhaps giving the trader the false impression that speculation is, at worst, neutral.
But what often happens is that an option trader is not willing to take a small loss to hedge when it will mean a small loss on the original trade. Eventually these small losses turn into large losses. In speculating by not hedging immediately or at all, many option traders cut their profits short, but let their losses run. For these traders, market-making profits are eaten up very quickly in speculative losses.
The best course is to avoid speculation, and to hedge delta whenever any option trade is completed that is not an option spread trade. If a trader waits to hedge delta in the best way, the outcome may be large losses. Hedge when you should, not when it is best.
 
Incorrect Delta (A) Hedging
Poor delta hedging entails trading options at prices that are un­realistic compared with the current futures price at which delta hedges may be traded. In other words, hedges cannot be done at posted futures prices because the board prices for some reason are lagging behind actual pit trading. If a market maker is limited to using futures prices as posted on the board to price options, he or she will be at a disadvantage and risk trading options at unrealistic futures prices. There are several ways to avoid this trap.
One way is to stand physically close enough to the futures pit to hear futures trading. If an option trader is able to do this, then he or she can hear, and even do, futures trades while trading options. But in large futures and options rings, where there is greater physical distance between the futures and options pits, it will not always be possible for an option trader to be near the futures ring. In this situation, a clerk may be necessary to signal by hand futures prices to the trader and to relay futures orders to the futures pit. This must be considered an added cost of business.
Another aspect of unrealistic futures pricing should be men­tioned. It is best not to be last in a string of large option trades in the pit, in order to avoid being in an infavorable futures hedging position. Brokers will sometimes come into the ring and immediately do a large quantity of single strike options spread among different traders. However, these trades are not done exactly si­multaneously. Traders who trade the last of a large lot order will find themselves at a competitive disadvantage when attempting to complete delta futures hedges because the impact on futures prices will already have been caused by the delta hedging of the first of the serial traders. What was a large profit for the first traders to do a string trade turns into a large loss for the last of the string traders, after futures prices have been run up or down by the first traders doing their futures hedges. Trading last on a string should be avoided whenever possible.
 
Overtrading
Another common mistake of option traders is overtrading, or impatience. Some market makers may get so bored from too much inactivity or not participating in trades that trades are done at net fair value. The market maker is not waiting for a sufficient edge to trade. Overtrading is unnecessary, and it may be wasteful if losses accrue because the profit margin is too thin.
A market maker should not look to trade all trades being done in the pit, but only to trade those at his prices. Of all trades done in the pit, there will be some minority of trades done at excessive discounts or premiums to fair value. Good option trading is waiting for these trades during the day, and not overtrading. There is no virtue in being the most active trader, only the most profitable. A good trader must be patient.
 
Poor Kappa (K)/Vega Risk Adjustment
A trader may become too long or short kappa/vega in context of the market liquidity on the opposite side. A trader does one side of an option trade repeatedly without a corresponding option spread trade. Even though the trader adjusts for delta neutrality, kappa/vega risk becomes lopsided. In the worst situation a trader has allowed a negative kappa/vega position to develop. This should always be corrected immediately.
The rule of thumb is to remain net long kappa/vega but not to get net kappa/vega more than may be neutralized without too large a loss if necessary. This amount is sometimes difficult to determine in practice and may be a judgment call in which errors will inevitably occur. To a considerable extent, judgment will be based on the trader’s appraisal of the net flow of pit/broker option trading.
Other Mistakes
One should also appreciate that clerical errors (mistakes in quantity, strike, month, or side) do occur, and they are truly inevitable. Perhaps one in 20 times, a small error is made. These are a cost of doing business and should be looked at philosophically.
More generally, traders will be making a mistake if they do not learn to relax during the trading day and take vacations pe­riodically. One of the advantages of trading limited-risk carryover positions is that a trader never needs to worry about financial catastrophe happening to him or her and may sleep restfully at night.
Periodic vacations are also in order, and may be conveniently arranged to begin after some expiration. Even if a trader does not liquidate his or her entire position, it is possible with planning to reduce position gamma to very low levels so that one need not be in daily contact with the market.

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