Trading options as

a Market Maker
Robbert Pullen
Trader
Trading trainer
Head of academic partnerships

3
 Founded in 1986 Market maker/ Privately owned
liquidity provider

We improve the market

By a single trader on We stabilize and We are privately
the Amsterdam’ improve financial owned by current and
Options Exchange markets former employees

~ 2000 FTE 11 offices across Own capital

4 continents

We have a global We are a multi- We use our own

footprint with 48 national company capital to trade,
nationalities represented with a global footprint at our own risk
We are a global firm

London, UK Amsterdam, The Netherlands

Chicago, USA New York, USA

Austin, USA Shanghai, China
Taipei, Taiwan
Hong Kong
Mumbai, India

Singapore

Sydney, Australia

6
 Over the past 37 years we have grown into a global firm

Expanded the business Opened offices

to the exchanges of in Sydney
Frankfurt and Paris 1996

1986 1990
2002 Opened Chicago
Founded by one trader 2000 office
on the Amsterdam
Options Exchange
with a mission to 1999
improve markets by Established US Developed floor
narrowing bid-ask operations in trading into
spreads New York City electronic trading
2010
Started
trading in
Brazil
2013
Expanded to
Shanghai Opened offices
in Austin and Opened office in
Singapore New York City
2016 2021
2023
Celebrated 30 years of history and
welcomed our 1,000th employee 7
 01 Financial markets and instruments

Agenda
02 Trading options as a market maker

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Financial markets and instruments
call / put
future A stock A option A
future B stock B option B
future C stock C option C
future D stock D option D
future X index X option X

ETF X option ETF X

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Market participants

Asset managers
Investment banks
Pension funds
Directional
Mutual funds
Retail investors
Others

Market Makers
Brokers
Non-directional /
Intermediaries
Market neutral
Internalisers
High-Frequency Traders
Others

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Liquidity

liquid illiquid
bid volume price ask volume bid volume price ask volume
44.67 8539 44.67 745
44.66 10551 44.66 496
44.65 3677 44.65
44.64 6800
Volume 44.64 400
44.63 9061 44.63 14
44.62 6693 44.62 500
44.61 6573
Bid-ask spread 44.61
2049 44.60 44.60
5176 44.59 44.59
1080 44.58 500 44.58
5000 44.57 44.57
16776 44.56 44.56
2000 44.55 202 44.55
15349 44.54 44.54
7800 44.53 421 44.53
11327 44.52 846 44.52

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Market Making

A market maker shows a bid and an offer i.e. a price at which (s)he
wants to buy and a price at which (s)he wants to sell the option

Example:
When a market maker believes an option's value is
44.60 eur, (s)he might want to buy this call option at
44.58 eur and sell it at 44.62 eur

A market maker does not want to take a directional position, unlike

directional market participants, but tries to buy and sell the same
product (many times) while capturing the money between the "bid-ask
spread"
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Hedge

Immediately after a market maker has done a buy or sell trade in an

option, the price of the option might move because of price changes in the
underlying asset

In order to avoid this price risk after an option trade, a market maker
"neutralizes" this price risk by doing a hedge

This hedge is a trade in another instrument than the option itself, mostly
the underlying asset (e.g. the stock), which generates the 'opposite profit /
loss' as the option trade does when prices change

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 • What is an option?
• Forward pricing
Trading options • Option pricing
as a • Volatility

market maker • Skew

• Greeks
• Implied vs realized volatility

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What is an option?

An option is a right, not an obligation

to buy (call) or to sell (put) an asset

at a certain price (exercise price or strike)

at a certain time in the future (expiration)

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Assumptions

In this lecture we focus on:

European style options

Call options

No dividends

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Call option at expiration

S S = 100 = market price

10 = advantage
X = 90 = strike price
(price when using call option)

expiration time
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Payoff of Call option
At expiration

C = max [ 0,(S – X) ]

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Expiration diagrams

Long call option Long put option

70 80 90 10 11 70 80 90 10 11
0 0 0 0

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Before expiration

What is the value of an option now?

In addition to any intrinsic value, there may also be a time value

Why would someone pay more for an option than just the intrinsic value?

How much more?

How do you determine this value?

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Building blocks of an option

intrinsic
value Intrinsic Value

time
value Time Value (or Extrinsic value)

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 Forward pricing

S
Forward (F)

Spot(S)

now expiration time

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 Intrinsic value

Call [ (F-X) * e−rt ]

Intrinsic
value
Discounted to
present value

S
Forward (F) F
F-X
Strike (X) X
Spot(S)

now expiration time

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 Time value

Parameters:
S = spot

S t = time to expiry
r = interest rate
X = strike
? = “probability factor”

Probability
F = 100 distribution
of ln(returns) 90 call
Spot(S) Intrinsic
value

Strike (X) X = 90 90 call 90 put

time time
value value

now expiration time

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Black-Scholes

At expiration:

𝑪 = 𝒎𝒂𝒙[𝟎, 𝑺 − 𝑿 ]
Before expiration:

𝑪 = 𝑺 ∗ 𝑵 𝒅𝟏 − 𝑿 ∗ 𝒆 −𝒓𝒕
∗ 𝑵 𝒅𝟐

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Black-Scholes
Before Expiration

𝐶 = 𝑆 ∗ 𝑵 𝑑1 − 𝑋 ∗ 𝑒 −𝑟𝑡 ∗ 𝑵 𝑑2

𝑆 σ2
ln + 𝑟+ 𝑡
𝑋 2 𝑑2 = 𝑑1 − σ√𝑡
𝑑1 =
σ√𝑡

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Historical Volatility

is more volatile than

S
Based on the known price data from the
past, the standard deviation of the price
changes can be calculated. This standard
deviation is called the historical volatility.

time

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Implied Volatility

?
historical implied
volatility volatility

now expiration

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Pricing Parameters

S spot = price underlying asset 𝐶 = 𝑆 ∗ 𝑁 𝑑1 − 𝑋 ∗ 𝑒 −𝑟𝑡 ∗ 𝑁 𝑑2

X exercise price = strike 𝑆 σ2
ln 𝑋 + 𝑟 + 2 𝑡
t time to expiration 𝑑1 =
σ√𝑡
r interest rate
σ implied volatility 𝑑2 = 𝑑1 − σ√𝑡

Higher implied volatility higher prices for both calls and puts

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In Practice…
Let’s calculate the call prices for different strikes (X)
and fill in the parameters below:

S spot = price underlying asset 𝐶 = 𝑆 ∗ 𝑁 𝑑1 − 𝑿 ∗ 𝑒 −𝑟𝑡 ∗ 𝑁 𝑑2

𝑆 σ2
t time to expiration ln 𝑿 + 𝑟 + 2 𝑡
𝑑1 =
σ√𝑡
r interest rate

σ implied volatility 𝑑2 = 𝑑1 − σ√𝑡

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Implied Volatility
(for different strikes)

Implied
volatility
skew
25

20

15

10

Strike (X)
80 85 90 95 100 105 110 115 120
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Normal Distribution

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Skewed Distribution

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Volatility Changes

Implied
volatility

25

20

15

10

Strike (X)
80 85 90 95 100 105 110 115 120
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Trading Volatility
ASK

Implied BID ASK

volatility

BID ASK
25
ASK
20 BID
ASK ASK
ASK ASK ASK
15 BID

BID BID
BID BID BID
10

Strike (X)
80 85 90 95 100 105 110 115 120
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What does a market maker do?

the MM calculates the call and and waits until someone

Based on the parameters: put values and shows both bid else trades with the MM,
and ask prices to the market i.e. buy/sell a call/put

S spot = price underlying asset

ask ask buy call
X exercise price = strike
sell call
or

t time to expiration call value put value or

buy put
r interest rate
or
bid bid
σ implied volatility
sell put

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Delta

𝝏𝑽 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒐𝒑𝒕𝒊𝒐𝒏 𝒗𝒂𝒍𝒖𝒆

∆= =
𝝏𝑺 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒗𝒂𝒍𝒖𝒆 𝒐𝒇 𝒖𝒏𝒅𝒆𝒓𝒍𝒚𝒊𝒏𝒈 𝒂𝒔𝒔𝒆𝒕

Delta interpretations
1) Change of value of an option (or portfolio) due to a change in the underlying

2) Probability of an option to expire in-the-money, i.e. with intrinsic value (by

approximation)

3) The number of shares of the underlying asset in order to hedge,

i.e. the equivalent weight of the underlying asset compared to the option

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Financial Instruments

call / put
future A stock A option A
future B stock B option B
future C stock C option C
future D stock D option D
future X index X option X

ETF X option ETF X

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Market Making and Hedging
stock A option A
bid volume price
44.67
ask volume
8539
1
44.66 10551
44.65 3677 price of stock A is input for
44.64 6800 calculation of option price
44.63 9061
44.62 6693
44.61 6573 low-latency
2049 44.60
5176 44.59
1080 44.58
5000 44.57
after a trade in option A
16776 44.56 a hedge order in stock A
2000 44.55 needs to be executed
15349 44.54
7800 44.53
11327 44.52 2
Stocks exchange PQR Options exchange XYZ
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Position Over Time

In real life you can’t buy and sell an options contract at the same moment.

So, you will have to keep a (hedged) option position over a period of time.

During this period of time, time value runs out of the option value.
Also the other parameters might change, which could be a risk.

How do Market Makers deal with this?

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Theta

𝝏𝑽 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒐𝒑𝒕𝒊𝒐𝒏 𝒗𝒂𝒍𝒖𝒆

θ= =
𝝏𝒕 𝒕𝒊𝒎𝒆 𝒑𝒂𝒔𝒔𝒊𝒏𝒈 (𝒄𝒍𝒐𝒔𝒆𝒓 𝒕𝒐 𝒆𝒙𝒑𝒊𝒓𝒂𝒕𝒊𝒐𝒏)

decreasing
time value

X
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Gamma

𝝏𝑽
Delta: ∆=
𝝏𝑺

After delta hedging no profit or loss is expected when the underlying S changes.

𝝏∆ 𝝏𝟐 𝑽
Gamma: Γ= =
𝝏𝑺 𝝏𝑺𝟐

This formula tells how many ∆‘s you get if the underlying asset S changes.

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Delta Changes

Replicating S by +C-P

1 ∆C - ∆P = 1

ΓC = ΓP

1 Indifferent in trading
calls and puts

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Realized Volatility
Both long call and long put options have positive gamma.
This positive gamma generates favorable deltas when the underlying asset (S) changes in price
In order to maintain a hedged (flat) delta position the MM does an additional hedge trade after S moved either higher or lower.

S at higher prices of S the option gained positive deltas, which can be sold

sell S sell S sell S sell S sell S

buy option
+
delta hedge
. . Realized
volatility

buy S buy S buy S buy S buy S

at lower prices of S the option gained negative deltas, which can be bought
t
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Summary

• A market maker calculates option prices based on available market data

• The MM shows a bid and an offer to the market
• If the MM does a trade, he hedges with the underlying asset (S) in order to be neutral for changes in the
underlying asset (S)
• This hedge is done by using the delta of the option
• Effectively, a MM trades volatility since the other parameters are ‘neutralized’
• Basically, a MM tries to buy options at a relatively low volatility and sell options at a relatively high volatility
level
• Buying and selling the options (i.e. volatility) doesn’t occur at the same time. Between the moments of
buying and selling the underlying asset (S) might change. Due to gamma the delta of the options changes.
• The MM dynamically hedges accordingly and ‘realizes volatility’ in this way as well

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Thank you!
Do you have any questions?

Robbert Pullen
Trading trainer

[email protected]
Strawinskylaan 3095
1077 ZX Amsterdam