“flippers” vs “warehousers”

Imagine a well-telegraphed large option seller is quoting an option worth $3.

A leading market maker quotes $2.80-$3.00, hoping to buy it for $2.90 if the seller offers mid-market. The seller will be happy with an optically good fill especially considering the size.

This type of thing happens all the time because other market makers will join the market and often not “cut it” if it’s a large order. This is completely reasonable — $2.90 is the price that may balance the capacity of the risk-capital to take down the trade.

There are a few dynamics to note:

1. A price often “finds” the same equilibrium in a non-collusive arrangement that is similar to what a collusive price would have yielded. This is because all the market-makers who are capable of pricing tight enough to compete for the order have all similarly pattern-matched that this is a seller and likely all roughly agree on fair value. If they create a bidding war, it is likely that they will still get a similar split as everyone else raises their bid but they’ll all just get a worse price. The logic comes from them having played the tit-for-tat game. Of course, the dynamics ebb and flow as different traders might revolve through the seats but given enough time in the chair, they will come to similar conclusions.
2. The market makers’ pricing depends on competitive dynamics. If one of the other bidders is a “flipper” type instead of a “warehouser”, they might be inclined to sell at $2.95 to lock in a profit even though the option is worth $3. This makes walking the option market back up to offer above fair value difficult. And since trades like this happen “by appointment”, these small differences can really ruin the exit if the market is framed too cheaply when the original client comes back to roll or close.

As you get into less liquid names (say outside of ETFs, indices and more into individual names), this is a much larger part of the game. The idea of “flippers” vs “warehousers” is alive and well in the market-maker landscape. The traders reading this know exactly what type of firm they work for, whether pricing or speed is their edge, and the p/l shapes they crave. By extrapolating from their own approach and what markets are suited for it, they can back into knowing who the players are in other names.

[If You Make Money Every Day, You’re Not Maximizing was inspired by my experience with this back in my days of trading gasoline and heating oil options. The capitalization of the other market makers played a role in how to trade it because I’d often end up with a position I wanted but it was also held by a trader who was more of a flipper than a warehouser. There were times when I’d anonymously use a broker to pay up a little to take their position from them. It cost me a little bit and rewarded them with an easy profit but they weren’t going away. On balance, I didn’t want their skittish pricing to anchor the market for larger size.]