Market Makers, Stabilizing or Disruptive?

Abstract

In this chapter, we will describe how options market makers or “dealers” can dominate price action over multi-day horizons. While they might not have large balance sheets, these agents take at least one side of a large percentage of trades that go through the market. When prices approach levels with significant options open interest, they can suddenly transform into Dominant Agents. In particular, market maker hedging can cause distortions in distribution of short-term returns. Volatility has the potential to either compress or explode: it all depends on positioning in advance of the move. With this in mind, we study stock pinning as an example of stabilizing behavior and downside index hedging as a mechanism for increasing the violence of sell offs and the speed of short-term rallies.