• How Options Drive Stocks
  • Hiking Prices at Market Open
  • Manipulating Behavior Using Customer Data

In this 3 part series former BoA trader Felix Frey explains the mechanics behind your Robinhood option trade showing every way that your order is picked apart for profit by professional firms like Citadel.

Part One – How Options Drive Stocks

Felix explains the art of delta hedging which allows big market makers to take the opposite side of your trade and process millions of transactions per day while minimizing market risk. The key takeaway is that each time you get big burst of demand in the derivative market it will spill over into the underlying market. So large buying of AAPL calls will result in rise of the AAPL stock price irrespective of any fundamental factors.

Part Two- Hiking Prices at the Market Open

In part two Felix focuses on the idea of implied volatility and how market makers try to profit off the movement of underlying stock during the lifetime of the option contract. The key concept to understand is that dealers are always adjusting their stock position up or down against the liability of the option contract they hold. The goal of their strategy is to capture more points in profit from the movement in the underlying security than the amount they are obligated to pay out when the option contract comes due. This is called volatility trading and this is how market makers like Citadel make money.

One way that market makers can make profit from the process is by controlling their implied volatility inputs. If they increase the volatility factor of their pricing algos then options become more expensive to buy and if they decrease it they become cheaper to buy. Usually at the market open when market makers know that demand for options will be high they will raise implied volatility making options contracts more expensive to buy. Felix compares it to an owner seeing customers approach his restaurant in the morning who quickly raises the price of bacon and eggs by 50 cents before anyone sits down for breakfast.

After the market makers have satisfied the morning demand they will begin to lower the implied volatility values which will keep option price lower. What that means in practice is that if you bought a call option on AAPL in the morning and AAPL stock price has risen by $1 the option on AAPL that you bought may not move at all because the market maker reduced the implied volatility reading on the option after selling it to you for a high price. In summary you can be 100% correct on your directional bet and still make no money on the option as the market maker would have have captured all movement profits by manipulating the volatility inputs.

Part Three – Manipulating Customer Actions

In part three Felix discusses the most potent tool in market makers arsenal – Artificial Intelligence. By constantly monitoring the aggregate positioning behavior of option traders, market maker’s computer algorithm can predict with uncanny accuracy how option traders will act in the near future. For example the AI may know that option traders will begin to liquidate their positions in a certain stock 30 minutes before the market close.

This knowledge allows the market maker to confidently sell the stock ahead of the retail trader order flow helping it to not only lock in better entry prices, but also trigger the very selling behavior it seeks as options traders panic at the prospect of falling prices.

In summary, this is why Citadel and other large market making firms are happy to pay $500 million dollars for the right to instantly fill your Robinhood option trades. The ability to execute your trades not only allows them to profit from bid/ask and volatility pricing schemes, but more importantly it allows them to collect data about your trading behavior which in turn gives the market makers the ability to correctly anticipate and profit from the retail trading flows during the day.