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This is a level 1 question.
What is opening rotation and how exactly are option prices kept in line with the underlying stocks or indices? Sometimes even though stock prices vary, the option premium does not change? What is the mystery behind this? Do market makers play an important role in all this?
In some markets, notably listed stock and stock index option markets, market makers may go through an opening rotation in which all of the option series in a particular underlying are opened in turn using a call auction procedure. The options can be opened all at once, opened just one month at a time, or in extreme circumstances they can be opened line by line. A similar reopening rotation may be followed if trading is interrupted due to a major development during the course of a trading day. A closing rotation may be followed to determine appropriate closing prices or quotes, particularly on inactive issues. Increasing reliance on automatic quotation devices encourages option specialists to open all series at once.
As mentioned above, the market makers or specialists who are responsible for the actual prices rely heavily on computers to update and keep everything in line. Using a driving price does this. The specialist sets the driving price and it in turn sets the parameters for the day's trading. However, he can change those parameters as the day progresses, thereby adjusting to new market conditions. The driving price parameters consist of how wide the bid-ask spread the market-maker wants on his options along with the volatility levels and the volatility skew that the market maker wants to set for his option book. In addition, the driving price can be set to show a better bid, a better offer or a neutral market price. This all depends on how the market maker is positioned. If the market maker is short, he can adjust the driving price to show a better bid and a worse offer. By showing a better bid, the market maker hopes to reduce his short position. This protects the market maker from getting too short as it hopefully entices others to sell to him or deters others from buying from him.
For a market maker watching 200-plus options, this level of computerization is a lifesaver. With everything this automated, the market maker can concentrate on the big things like the underlying stock's price movements and the large individual orders that could influence his position and prices. Without the driving price and its parameters, the market maker would spend all of his day just doing menial price updates. This would lead to slowdowns and vast inefficiencies. It would also make the market maker more hesitant to make prices because he would fear getting picked off on some arbitrage trade.
Some of the differences we see during the day can be due to a variety of reasons. Sometimes a specialist is just slow to adjust prices. On multiple listed options, the various exchanges can see each other's bids and offers. Members of the crowd can sometimes yell at the specialist if they see business being done away from their particular exchange and ask the specialist to show a more competitive price, thereby routing orders to their exchange. Other times a specialist may be positioned wrongly and is hesitant to adjust prices and hurt himself even more.
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Question Level Key
Level One--Basic Jargon, Definitions, Basic Mechanics of Trading.
Level Two--Introductory Points, Practical Points and Simple Strategies
Level Three--More Advanced Strategies and Repairs
Level Four--Risk Management, Psychology, and How Best to Evaluate Things.
Level Five--High end questions concerning Portfolio Analysis, Managing a Portfolio
of Options, Option Pricing Models, and Nuances of Trading. Included could be a variety of
other topics.
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