Crypto Options Market Making – A High-Stakes Game of Risk and Reward

by
Autowhale
|
December 12, 2023
|
Algorithmic Trading Software

In contrast to spot market making which most token projects are looking for crypto options market making is a more sophisticated trading endeavor that leverages contracts on derivatives exchanges.

Crypto options market making refers to the process of providing liquidity to a market by creating and offering options contracts for sale. This involves the market maker setting both the bid and ask prices for the options contracts, with the goal of profiting from the spread between the bid and ask prices.

In general, a market maker is an entity that maintains a market in a particular crypto derivatives instrument by standing ready to buy and sell that instrument. In the case of crypto options market making, the market maker is providing liquidity to the market by offering options contracts for sale. These options contracts give the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (the strike price) on or before a specific date (the expiration date).

The role of the crypto options market maker is to continuously create & offer options contracts for sale in order to facilitate trading in the market. This requires the crypto market maker to have a deep understanding of the underlying crypto asset and the given options market, as well as the ability to use algorithms and software tools to monitor the market and identify opportunities to create and offer orders on that options market.

Overall, crypto options market making is a crucial part of the financial ecosystem, as it helps to provide liquidity to the market and enables traders to take positions in options contracts.

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Types of crypto options

There are two main types of crypto options: call options and put options. A call option gives the holder the right, but not the obligation, to buy an underlying asset at a predetermined price (the strike price) on or before a specific date (the expiration date). A put option gives the holder the right, but not the obligation, to sell an underlying asset at a predetermined price on or before a specific date.

Call options are typically used when a trader expects the price of the underlying asset to increase. For instance, if he or she believes that the price of Dogecoin is going to increase, he or she may purchase a call option on DOGE option contracts with a strike price of $50,000 and an expiration date of that options contract. If the price of DOGE now increases to $55,000 or higher, the trader can has the right to buy DOGE at the strike price of $50,000. Therefore the trader made a profit on that options position.

Put options, on the other hand, are typically used when an investor expects the price of the underlying asset to decrease. For example, if an investor believes that the price of Ethereum is going to fall, they may purchase a put option on Ethereum with a strike price of $2,000 and an expiration date of six months. If the price of Ethereum decreases to $1,800 or lower within six months, the investor can exercise their right to sell Ethereum at the strike price of $2,000, resulting in a profit.

It's worth noting that both call options and put options can also be used as a way to hedge against potential volatility in the underlying asset. For example, a Bitcoin miner may purchase put options on Bitcoin as a way to protect against the risk of a drop in the price of Bitcoin. It therefore also limits the exposure to gains in the market and makes the miner only exposed to the actual profits of the mining operation.

Crypto options market making for token projects

For token projects it may not be apparent that crypto options market making can be relevant for a token market, however, in some cases crypto options are a valid option to hedge token inventory in order to run a delta neutral market making strategy. To find fitting hedging methods, it is important to understand the relation of the tokens market dynamics to the given option.

This is specifically the case for tokens that do not have options markets. In such case a hedge can be found by, for example, find some basket of option markets with a strong correlation to the tokens price. By building a system that hedges via such methods, a token project can run a semi-optimal crypto market making strategy that is delta neutral.

Crypto options market making

How does crypto options market making work?

Crypto options market making involves the continuous creation and offering of options contracts for sale in order to facilitate trading in the market.

In order to be successfully build a crypto options market making strategy, it is important for the market maker to have a thorough understanding of the underlying asset and the options market, as well as a strong grasp of crypto market making strategies. This may include the use of hedging strategies to reduce risk and manage positions, as well as the ability to adapt to changing market regimes.

Ultimately, crypto options market making is a complex and dynamic process that requires sophisticated models and strategies that are applied to optimally provide liquidity in a given market. It is an important part of the crypto ecosystem, as it makes markets tradable by providing liquidity and enables traders to take positions in such crypto options contracts.

Risks involved in crypto options market making

As with any trading activity, crypto options market making involces risks and challenges. Some of the key risks and challenges that crypto market makers may face include:

  • Volatility in the underlying asset: The price of the underlying asset can be highly volatile, which can lead to significant losses for the market maker if they are not properly hedged.
  • Counterparty risk: There is always the risk of counterparty default, where the other party in a trade fails to fulfill their obligation. This can lead to significant losses for the market maker.
  • Liquidity risk: If liquidity dries up in the market, it may be difficult for the market maker to exit their positions or execute trades, leading to potential losses.
  • Regulatory risk: Changes in regulatory frameworks or enforcement actions can have a significant impact on the market and the market maker's ability to operate.
  • Competition: Market makers may face competition from other market makers or from proprietary trading firms, which can impact their profitability.

Overall, it is important for market makers to be aware of these risks and to have strategies in place to mitigate them. This may include the use of hedging strategies, risk management protocols, and the ability to adapt to changing market conditions.

None of the content above is financial advise and is for educational purposes only. Find more content on algorithmic trading software, crypto market making and market microstructure on Autowhale’s blog.

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