I understand how market making works in general but i dont understand the transition to options. I am interested in the market making process of options, risk management, hedging, and theory vs practice. Anyone have any good resources, or experience in this field?
For instance, my knowledge just goes as far as posting the 2 sides, bid offer then either flipping or hedging in similar contract. I know its very simplistic but i am looking for how people generate models for MM, or strategies to reduce adverse selection.
I used to be an options market maker at a prop firm, when I was starting out I found there was very little educational material for options trading that is in a market making context, and it is of course very dependant on the market you operate in and how much you are participating as a market maker.
You calibrate the inputs to your BS model (ie vol, skew, theta decay, kurtoisis) so your prices are broadly in line with other market makers. On a portfolio level your aim is to keep your levels of tau, gamma, skew within certain tolerances across each product/month, though you would have different contracts/months offsetting each other. You may at times decide to be ie. long gamma back off a view of anticipated client flow or a market view, but you are normally looking to trade into positions with +ve theoretical edge (TE) that you would be able to get out of (by working positions with offsetting risk levels) when the opportunities arise. On a strike specific level, you are constantly looking at synthetically equivalent positions to find value. For example, there maybe be an opportunity to buy on screen the 40/50 call spread for 0.2 TE (ie. 0.2 under where your model has it valued). You might not deem that as sufficient edge to take on that position, however you can also sell the 50/60 call spread for 0 TE - combining the two together, buying the 40/50/60 butterfly for 0.2 TE might seem more palatable. If you are primarily a vol player, you obviously hedge your delta each time you trade the options but there is no hard and fast rule of how to gamma hedge, it's more about having a feel and using your discretion.
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