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Why do options market makers take on short volatility positions?

Adapted from Options Volatility and Pricing Textbook by Sheldon Natenberg.

Option market makers typically profit when there is more options volume being traded. The reason for this is market makers profit from the difference in the bid-ask spread, and higher volume provides and opportunity for them to take in more profits on this spread.

When options trading volume is elevated, you also tend to see higher volatility in the market. This is because demand for options increases as volatility increases due to market participants purchasing protection for their portfolios and/or speculators looking to profit from large price swings.

Market makers have an indirect long volatility position

As a result of this, option market makers have what is known as an indirect long volatility position, because they profit when volatility is high as a result of increased volume. Market makers want an increase in the volume of options but not because they have long volatility positions per se.

To hedge against this indirect long volatility position, you will see market makers take short volatility positions in volatility contracts, most commonly the VIX.

The market maker takes a short volatility position because they want to hedge themselves against the possibility of there being low trading volume which would ultimately hurt their profits.

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Author: Trader Court

CPA first, pivoted to python programmer focused on data science which I apply to my own stock and options trading.

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