How do you think professional market makers/takers, who are well capitalized consistently make money? Why are they well capitalized? In other words, why do banks back these guys? Remember, bank directors have a fiduciary responsibility, mandates and have to answer to management, shareholders, the SEC the NASD, yada, yada, yada. One hint is they don’t make money the new fashioned way. The answer is that Pros are, by and large, premium sellers. They can be, because they are well diversified through the products allowing for the occasional bloody beating when a stock does a tap dance on their wind pipe. But what happens when the whole market goes…you know…goes really big, in one direction, fast and far, across the board, in all the products? Meaning: you can throw the idea of diversification out the window. Insight: Wings. By owning, that is being long cheap wing premium, one is given permission to short closer to the money, beefier premium. The proof is in the implied volatility (IV) skew, the smile. To the public and speculators high implied volatility represents an over-priced opportunity motivating them to sell OTM options. The smile is caused by options inventory guys, that is, market makers, hoarding the wings. Did you ever notice the price, in terms of dollars and cents, of those high implied volatility options? They are the cheapest options available in those underlying instruments and this is the reason that market makers can sell premium across all sectors, and the reason that the banks can back them and remain comfortable with the firm’s exposure. They may lose money here and there, but when the nightmare hits, these institutions with extra-long wings score big. They avoid getting destroyed like victims of derivatives debacles. Why? Their wings kick in and it rains money.