Market Makers in Binary Options
Buyers and sellers do not automatically get matched to each other in the binary options market in such a way that the lost investment of one party is used to pay for the gains of the other party. Usually there will be a middle man in the entire process. This middle man is there to make sure that there is enough volume of trade so that buyers can get their orders matched to sellers and vice versa. This middle man is the market maker, and the job of the market maker is simple: to provide the market liquidity. The market maker “makes the market happen”.
But are market makers all about liquidity alone? How do market makers enhance liquidity in the marketplace? A closer inspection will tell us a little bit about these guys and how they influence the market.
How Market Makers Influence the Market
One of the functions of a market maker is to provide pricing for the asset to be traded. Usually a trader will look at a price and wants to purchase the asset at that price, while a different trader will view the asset another way and would be looking to sell the asset at that same price. So we have two parties, each with opposing viewpoints. So the market maker looks at these two guys, and decides to set a price to bring them together. So for instance, the market maker would make a price at 48–51 (48 for BUY and 51 for SELL).
In a theoretically perfect setup, two traders would place a trade at the same time on these prices. One trader thinks the asset is to heavy and will lose value, hence he goes short with 1 lot (NADEX) or 1 contract of investment amount (online binary options platform) at a price of 48. This trader is a seller.
The other trader thinks the asset is undervalued and would likely gain in price, hence he decides to go long with 1 lot or 1 contracted investment amount at a price of 51, thus becoming the buyer.
Both traders having set their trades decide to hang on until expiration without placing another trade. Now what has happened here is that the market maker provided enough liquidity in the market and set a price that both traders can work with immediately, without assuming any exposure. The act of providing liquidity means that the market maker bought 1 lot of the asset from the selling trader at 48, and then sold 1 lot of the same asset to the buyer at 51, thus making a profit of 3 points while satisfying the trade orders of both sets of traders, without regard as to where the asset will eventually end on expiration.
Now forget the perfect theoretical setup and enter into the real world of market making. Here, there are going to be so many different individual traders, with varying financial strengths, varying account sizes and varying trade sizes. You would rarely find a situation where two traders would trade exactly opposite positions with the same trade sizes, and at the same time. So what we would see in the real sense, is that the market maker would keep posting different prices. The pricing may start at one level (say 48 – 51 as in our previous example), but as time passes and the search for matching orders on the opposing side continues, the price may move to settle at a different point, say, at 68–71 and then suddenly drop to 23 – 26. So you see a scenario where sellers and buyers of an asset come along randomly, buying and selling with different contract sizes, different investment amounts at different times and therefore at several different prices set by the market maker.
Market makers will therefore constantly tweak their pricing to make it more attractive to some traders, when there are a lot of traders seeking opportunity in the market. So the market maker may tweak price to the upside by a few points to encourage some sellers looking for a few points bargain, to enter the market and balance out the risk. Likewise, when there arr a lot os sellers pushing the asset at a particular price, the market maker may tweak price a few points to the downside so that some buyers can get in to balance the risk.
This act of continuously moving price, balancing and rebalancing, is hardly a perfect situation. How can it be when sometimes a market maker may be dealing with close to 50,000 traders in the market at once? Rather binary option market makers tend to averaged out the contracts over a period of time so that on the average, the market maker’s average buying price would be slightly lower than the average price at which the contract is sold to sellers and vice versa. In addition, in the financial markets there will always be more losing traders than winning traders and this helps the market maker to stay in business.
Pros and Cons of Market Maker Operations
What are the pros and cons of market maker operations in the binary options market?
PROS
Obviously in a market which struggles to provide liquidity that matches what is seen in forex and other financial markets, the role of market makers in binary options is very important. By setting prices, they are able to provide better entry points for those wishing to buy or sell an asset.
In addition, being able to provide matching orders at any point in time is a hallmark of market maker operations. This is good for traders so that there are not time-based restrictions on when they can find tradable opportunities in the market.
CONS
In unregulated setups, market maker operations could open the door to a wide range of pricing irregularities such as stop hunting against traders’ positions. This is especially seen in the 60 seconds contract and other short term contracts in many online binary options platforms. The CFTC has indeed punished many market maker brokers for such infractions.
Conclusion
When traders better understand the role that market makers play in the binary options market, it will provide them with a better understanding of the market dynamics and aid them to improve their skill at picking the best prices with which to accomplish winning trades.
