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Market Maker Survival: The Options Pit “Caste System” Revealed
By Lee Lowell, Advisory Panelist
Tuesday, September 20, 2005: Issue #243
So you want to know what market maker survival is all about? What it’s like being a market maker? Well, you’ve come to right place… I spent many years as a market maker on the floor of the New York Mercantile Exchange (NYMEX).
And today, I’m going to give you the breakdown of how a market maker thinks, acts and operates when an option order hits the pit. On top of that, I’ll explain the fierce Darwinian struggle that takes place day in, day out at markets like the NYMEX.
This will give you a better understanding of who’s taking the other side of your trade, and why that person isn’t always trying to “take you.” You’ll also see who holds the advantage in getting your options orders filled.
Remember, these facts and stories only apply to my experience during my days on the NYMEX. Let’s get right to it…
How Market Makers Are Like Gladiators
First, we need to understand the makeup of the options pit and how market makers fit into that arena. Believe it or not, there is a sort of hierarchy, or caste system, that prevails in the options and futures pits.
The days of a newbie market maker are not all that much fun. You are essentially the low man on the totem pole in that ring. You need to prove yourself not only to the other market makers, but to the brokers as well.
An options or futures pit on an exchange floor is made up of three or four concentric circles, with a raised rim or step along the outer edge of each circle. Each circle is elevated higher and wider than the next so there are people standing on higher or lower steps in relation to their front-side or backside neighbor.
Just think of a sports stadium without the seats, where everyone has to stand instead of sit.
These steps form the pit hierarchy. The brokers are the ones who get to be on the highest step. This is because they need to be near their phones, which are installed in small wooden booths that align the outer edge of the top step. The brokers are the ones who have all the orders. They get their orders from either retail customers (you and me), or from their in-house traders who take positions for the firm (Goldman Sachs, Merrill Lynch, Citibank, etc.), or from other big institutional firms.
Stay Close to the Brokers
Make no mistake, you want to be in good with the brokers, and you want to be as close to them as physically possible. A market maker is only as good as the amount of orders he/she can get involved with. If you’re a market maker and you don’t make any trades, how are you going to make any money?
To make sure they do, here are two of their missions:
- Just try to survive.
- Eventually move yourself up in the pit to be as accessible to the brokers as possible.
Sounds easy, but it’s not. You have to contend with other market makers who have been standing in the same spot for years, and they’re certainly not going to let some green rookie take their place.
Why You Want Your Broker to Be Big and Loud
I remember the first two words I heard the very first day I stepped into the pit as a market maker, “fresh meat.” That’s right, market makers and brokers will prey on the new guy as a sort of initiation. It happened to me, and will most likely happen to every other new guy as well.
Most of the new market makers will start on the lowest step, which is the farthest place from the brokers, or they just try to squeeze into a space wherever they can. Being timid or shy at this point is not a good thing. You need to assert yourself as quickly as possible.
I think the exchanges are one of the last places in the work field where being physically big and loud has a huge advantage for you. That is what gets you noticed. That’s why sometimes you’ll see many former ball players getting jobs as brokers or other types of floor traders.
How Market Makers Survive
Nevertheless, all new market makers will be feeding off the scraps of orders that were not taken by all the bigger, faster, louder and more senior traders in the ring. You take what you can get at first and work your way from there. It’s tough being at the bottom, but if you’re good, you can move up quickly.
So there’s the true insider view of the options markets and how the market makers survive. As you can see, they’re just guys trying to make a living. And if you have a good one working for you, he can help you make a good deal of money, as well.
In the next installment of this semi-regular series on market makers, I’ll explain exactly how an option order gets filled from start to finish, and how the market maker fits into that equation.
Until then…
Good trading,
Lee
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Along with Karim, Lee is one of America's leading options professionals. Over the course of a distinguished career, which includes six years in the options "trenches" as a market maker on the floor of the New York Mercantile Exchange (NYMEX), he has developed a proprietary trading method capable of enormous upside while actually reducing risk. 
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