In the last option trading blog I defined non-directional trading. Let’s look how it has evolved “on the floor”.

Twenty years ago option Market Makers had a tremendous “edge” being on the exchange floor and they made a great living without having an opinion. Orders were verbally represented to the crowd and executed. The information was slowly disseminated and it took forever to know if you were filled. It gave the Market Makers plenty of time to adjust their markets based on order flow. As a veteran in option order execution, I will tell you that there were times when the process felt like a “grab bag”. You would stick your hand in and you never knew what you would pull out. In the “80’s”, Market Makers were able to leg into conversions and reversals with relative ease, locking in risk free profits. They were making great money! Over time, competition and technology started to “bite” into that edge.

By the mid 90’s, Market Makers were forced to develop multi-leg strategies that they could leg in and out of to hedge their overnight risk. Remember, Market Makers feed off of order flow and they only buy bids and sell offers. Their commission costs and margin requirements are a small fraction of the retail public’s and that is still an advantage granted to exchange members. These strategies still exist and can generally be grouped as complex spreads. They include 4-ways and condors and iron butterflies. The premise is that the position is neutral and very hedged. Think about this carefully. Imagine seeing all of the order flow on the floor, paying a dime a contract for clearing (no commissions no minimums), having a fraction of the margin requirements, adjusting your markets instantly based on the underlying and legging into trades. The competitive edge they have over you for complex spreads it monumental.

By the late “90’s” it was apparent the exchanges were going after each other and fighting for listings. The monopoly that had existed (IBM only traded on the CBOE, DELL only traded on the PHLX) was going to be broken up and the bid/ask spreads would have to tighten to attract order flow. To make matters worse, electronic quote systems were improving and electronic trade execution was lightening fast. The Market Makers had to be sharp and fast to survive. There was also the threat of an electronic options exchange (ISE). By the late “90’s”, no one on the floor knew his or her fate.

Even with all of the advantages of being on the floor, these complex neutral strategies were barely paying the bills. By the end of the millennium, Independent Market Makers were making $75,000 a year after expenses. It’s a living, but I don’t think that is what you have in mind. The Independent Market Maker is all but extinct and most have a salaried position (with a year end bonus) with a large firm.

These facts don’t stop people from teaching complex spreading strategies. As long as the instructors know more than you do, they’ll charge you $3000 and tell you how easy and risk free it is.

Non-directional trading is now being played by large institutions with deep pockets, a very low cost of capital, the ability to “leg in”, access to over-the counter markets, minuscule transaction costs and instantaneous hedging programs. They have traders at every post on the floor. Let them have this space. It is a very tilted playing field. These strategies can make money for months on end and all it takes is one big move to lose everything.

Imagine an Iron Condor where you have four bid/ask spreads on the way in and four commissions. Imagine that you have to take one side off. You have another two bid/ask spreads and two commissions. Is the picture becoming clearer?

The point, learn how to become a directional trader.

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