Speculators vs Hedgers

Derivatives generally exist as a tool for one party to transfer risk to another. So in that sense, players in the option markets are either those looking to avoid risk and those looking to take on risk. Broadly, they can be categorized as Speculators (risk taking) and Hedgers (risk avoiding).

A speculator will use capital that he or she is prepared to lose in order to take a view on the price movement (or volatility in the case of options) of an asset, such as a stock. A hedger on the other hand, will be someone with an existing position that will then use options as a means of offsetting some (or all) of the directional (or volatility) risk of that underlying position.

Trading styles, however, can often be a blend of both speculating and hedging. For example, a retail trader may primarily be a speculator as his/her involvement in the markets is purely to make money on market moves but still may use risk reducing strategies such as a collar or covered call to remove some risk from their position. These trades may be considered a hedge to some as they are implemented to remove directional risk from the underlying stock position.

A more descriptive way of identifying the "who's" of the option markets is to list the main types of participants and outline what type of trading they do.

Market Makers

Market Makers are the biggest contributors to volume and turnover in the option markets. Market makers are trading firms or institutions who are usually obliged by the exchange to provide two way price quotes on individual option contracts in return for lower exchange fees.

Two way prices are essential in promoting liquidity as price takers know that if the trade starts to go against them, they will have an opposing price to exit with. This bid/ask spread provided by the market makers provides an assurance that traders won't be "stuck" with an unwanted position.

Note: not all firms who trade in this way are necessarily market makers, nor always incetivized by an exchange. Some exchanges e.g. Korea, do not have a formal market making program but there is still no shortage of firms providing two way prices quotes onto the KOSPI Index options. Firms will still trade the KOSPI as a market maker because they have a strategy that involves trading the bid/ask and hedging that can make money regardless of there not being a fee reduction program in place.

Retail Traders

A retail trader is generally the holder of a small account of his or her own money that invests in the markets for financial gain on their holdings. Retails traders may also be classified as non-professional, however, a non-professional classification can also depend on a number if "usage" factors:

Definitions of Professional Users According to the NYSE and Most US Exchanges

Retail traders will trade options as speculators; establishing positions in options based on a view of the underlying asset. They may, for example, simply buy calls or puts purely on the opinion of a stock going up/down or use options to create a more defined price pattern of the underlying instrument i.e. That it stays range bound between a higher and lower price band e.g. Iron Condor or Strangle.

It is also common for retail traders to also use more conservative approaches to option trading. Many traders now utilize a range of popular "income generating" strategies like buy-writes (covered calls), short condors on indices and short puts on bullish favored stocks.

Despite the increasing volumes amongst the non-professionals, much has been said of the low percentage rates of successful retail traders.

...academic research suggests that on the whole, options traders do worse than stock traders, who, in turn, have been shown in many studies to underperform buy-and-hold investors. The most comprehensive study looked at 68,000 Dutch retail investors. It found that from 2000 to 2006, retail options traders lost an average of 4.5 percent each month, while people who just traded stocks lost 1.6 percent.

So while the lure of large, fast gains is appealing it is important for retail traders to start small and only risk money that you are fully prepared to lose.

Proprietary Traders

Prop traders are speculators who trade for either banks or large institutions using that firms own capital for risk taking positions. Prop traders may use options as a speculative tool for either directional type of trading or volatility.

High Frequency Traders

High Frequency Trading (HFT) is a style of electronic trading that can be used by trading operations as few as two or three people up to large organizations employing hundreds. Typically HFT use arbitrage strategies where they attempt profit from small discrepancies is the price of one asset vs the price of either the same asset traded on another exchange or another asset that has a comparable value.

Stock Example: MSFT shares are traded on both BATS and NASDAQ. Many firms will attempt to buy MSFT on one exchange and sell it immediately on the other for a profit. Because these stocks are highly liquid a bid/ask spread showing an immediate profit across both exchanges is extremely unlikely. Traders therefore need to leg one side on one exchange basis the opposing price on the other. When their open orders is hit, they will send the other side immediately in order to capture the profit.

Option Example. Similar to the example above, a market maker will "rest" orders, bids AND offers, in multiple option contracts to either hedge with the bid/off of the underlying instrument (see delta hedging) or to trade it against another option in the same underlying to offset risk.

Both of these trading strategies can be classified as High Frequency Trading.

Strategies of this nature require significant investment. Trading firms engaging in HFT need state of the art servers, native access to exchange interfaces, high throughput access lines to exchanges, co-location facilities for their equipment at, or next to, the exchange matching engines and also the IT/development resources required to build and maintain the HFT algorithms.

Despite the massive investment required, the majority of the volume that trades on electronic option exchanges would originate from a firm engaging in some kind of HFT strategy.

Portfolio Managers

A Portfolio Manager is a trader (or group of traders) acting on behalf of somebody else's money. They would be classified as an "Institutional Investor" due to the usually large volumes they execute.

Portfolio Managers may be traders inside an investment bank, managers of Exchange Traded Funds (ETFs), money managers of high net worth families or retirement fund managers (pension funds, unit trusts, superannuation).

They will typically hold longer term positional view of assets in their accounts on behalf of their investors. The majority of the assets held by portfolio managers will most likely be equities (stocks). Some may then use the option market as a way of reducing risk in their portfolio. E.g. A Portfolio Manager may buy long dated index put options in case of a large market correction. Doing this provides some form of insurance if the broad equity market crashes.

Due to the large portfolio size that many PMs manage ($14 trillion in US Pension Fund capital during 2015), the volume of options that they execute can sometimes be many multiples of the average daily turnover in a single option contract. Following these large footprints can often lead to nice trading opportunities for the retail trader.