1.3 & 1.4 Market Making And Profiting As A Market Maker

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1.3 & 1.4 Market Making And Profiting As A Market Maker - Quiz


Questions and Answers
  • 1. 

    Exchanges need market makers to _____ (may select multiple answers).

    • A.

      Sell straddles

    • B.

      Provide liquidity to the market

    • C.

      Put on large positions

    • D.

      Provide price stability

    Correct Answer(s)
    B. Provide liquidity to the market
    D. Provide price stability
    Explanation
    Exchanges need market makers to provide liquidity to the market by constantly buying and selling securities, ensuring that there is always a ready market for traders to enter or exit their positions. Market makers also help provide price stability by narrowing the bid-ask spread and preventing extreme price fluctuations. Their presence in the market ensures that there is sufficient trading activity and reduces the risk of illiquidity.

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  • 2. 

    A market maker quotes a bid-offer spread on an option(s) by showing a bid under his theoretical value and an offer over his theoretical value, if the market he makes is not faded.

    • A.

      True

    • B.

      False

    Correct Answer
    A. True
    Explanation
    A market maker quotes a bid-offer spread on an option(s) by showing a bid under his theoretical value and an offer over his theoretical value, if the market he makes is not faded. This means that the market maker is willing to buy the option at a lower price than his estimated value and sell it at a higher price. This spread allows the market maker to make a profit from the difference between the bid and offer prices. If the market maker's quotes are not faded, it indicates that there is a demand for the option at those prices, making the statement true.

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  • 3. 

    You can imagine an options market maker like a casino taking bets at a roullette wheel.  The optimal situation is in which a better enters the casino and places his entire bet on one number/line.

    • A.

      True

    • B.

      False

    Correct Answer
    B. False
    Explanation
    An options market maker is not like a casino taking bets at a roulette wheel. In options trading, market makers facilitate the buying and selling of options contracts by providing liquidity to the market. They do not take bets or place their own money at risk. The comparison to a casino is inaccurate and misleading. Therefore, the statement is false.

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  • 4. 

    The difference between the trade price and current fair value of an option is referred to in our industry as _____

    Correct Answer
    edge
    Explanation
    In the context of the options trading industry, the term "edge" is used to describe the difference between the trade price and the current fair value of an option. This difference represents an advantage or an edge that traders can exploit to make profitable trades. By understanding and analyzing this edge, traders can make informed decisions about buying or selling options, potentially maximizing their profits.

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  • 5. 

    Typically the more ________ a market is the tigher the bid/offer spreads.

    Correct Answer
    liquid
    Explanation
    A liquid market refers to a market with high trading activity and a large number of participants. In such a market, there is a higher volume of buying and selling, which leads to a higher level of liquidity. This increased liquidity allows for tighter bid/offer spreads, meaning that the difference between the highest price that a buyer is willing to pay and the lowest price that a seller is willing to accept is smaller. This is because there are more buyers and sellers available to match orders, resulting in a more efficient and competitive market.

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  • 6. 

    By collecting the difference between the bid/offer and fair value, you make riskless money.

    • A.

      True

    • B.

      False

    Correct Answer
    B. False
    Explanation
    This statement is false. While collecting the difference between the bid/offer and fair value may seem like a riskless way to make money, it is not always the case. The bid/offer spread represents the cost of trading and reflects the market's liquidity and volatility. The fair value is the estimated intrinsic value of an asset. The difference between the bid/offer and fair value can vary and may not always result in riskless profits. Market conditions, transaction costs, and other factors can affect the profitability of this strategy.

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  • 7. 

    A _______ _____ is when the clearing firm asks you to put up more capital to cover your position.

    Correct Answer
    margin call
    Explanation
    A margin call occurs when the clearing firm requires the investor to deposit additional funds to cover the potential losses of their position. This is typically triggered when the value of the investor's collateral falls below a certain threshold, as determined by the firm's margin requirements. The purpose of a margin call is to ensure that the investor has enough capital to cover their obligations and minimize the risk of default.

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  • 8. 

    It is possible to be correct long-term on a position but get squeezed out/forced to exit in the short-term, thus not realizing any profit.

    • A.

      True

    • B.

      False

    Correct Answer
    A. True
    Explanation
    This statement is true because even if a position is correct in the long-term, market conditions or external factors can cause short-term fluctuations that may result in being forced to exit the position before realizing any profit. This can happen due to factors such as sudden market volatility, unexpected news events, or changes in investor sentiment. Therefore, it is possible to be correct in the long-term but not realize any profit in the short-term due to these factors.

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  • 9. 

    Eji's position (may select multiple answers)

    • A.

      Was not hedged properly

    • B.

      Was given up to the clearing firm as he did not post additional margin

    • C.

      Was too big to manage

    • D.

      Lost money in the short-term but would have made money in the long-term

    Correct Answer(s)
    B. Was given up to the clearing firm as he did not post additional margin
    D. Lost money in the short-term but would have made money in the long-term
    Explanation
    The given answer suggests that Eji's position was given up to the clearing firm because he did not post additional margin. This indicates that Eji's position was not properly hedged and resulted in losses in the short-term. However, it is implied that if Eji had posted additional margin, the position would have eventually made money in the long-term.

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  • 10. 

    In the article "How markets use information to set prices" Mike Moffatt discusses contingency contracts. Suppose such a contract will be worth $1 if it rains today and $0 if it does not. If the current forecast is predicting a 70% chance of rain, the contract should be trading _____

    Correct Answer(s)
    0.70, $0.70, .70, $.70, 70, seventy cents, 70 cents, .7, $ .70, $ .7
    Explanation
    The contract should be trading at $0.70 because the current forecast is predicting a 70% chance of rain. This means that there is a 70% probability that it will rain, and in that case, the contract will be worth $1. Therefore, the expected value of the contract is $0.70.

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  • 11. 

    A contract which is contingent on who will win the MLB all star game will be worth $1 according to which team wins. Before the game starts, it is trading $0.50 because both teams have an equal chance of winning. During the first few innings, getting 2 men on base might move the price of the contract to .55, and with 2 outs and a 0-0 score a strikeout might move the price back to .50. How would these same events move the price if they occured in the 9th and final inning?

    • A.

      No change

    • B.

      Greater price swings

    • C.

      Smaller price swings

    Correct Answer
    B. Greater price swings
    Explanation
    In the 9th and final inning of the MLB all-star game, the outcome of the game becomes more certain as it nears its end. Therefore, any events that occur during this inning, such as getting 2 men on base or a strikeout, will have a greater impact on the perceived likelihood of each team winning. This increased certainty will lead to greater price swings in the contract, as the market reacts more strongly to these events and adjusts the price accordingly.

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  • 12. 

    The day of the all star game, a contract which pays $1 if they Yankees (an American League team) win the world series is trading 0.20. The winner of the all star game wins home field advantage in the world series. After the American League won the all star game, what happened to the price of the contract?

    • A.

      Decrease

    • B.

      No change

    • C.

      Increase

    Correct Answer
    C. Increase
    Explanation
    After the American League won the all-star game and secured home field advantage in the World Series, the likelihood of the Yankees winning the World Series also increased. This increased probability of the Yankees winning the World Series caused the price of the contract to increase.

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  • 13. 

    What did the bank do with EJI's position after he declined to meet the margin call?

    • A.

      Deleted his account and position.

    • B.

      Asked the marketplace for bids to buy the position.

    • C.

      Forfeited the position to the SEC

    Correct Answer
    B. Asked the marketplace for bids to buy the position.
    Explanation
    After EJI declined to meet the margin call, the bank did not delete his account and position or forfeit the position to the SEC. Instead, they asked the marketplace for bids to buy the position. This means that the bank sought potential buyers in the market who would be interested in acquiring EJI's position. By doing so, the bank aimed to sell off the position and recover any potential losses or mitigate further risks associated with EJI's position.

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  • Current Version
  • Jan 29, 2024
    Quiz Edited by
    ProProfs Editorial Team
  • Jul 13, 2012
    Quiz Created by
    ConsolidatedTrad
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