A story on how an options secondary automated market maker (AMM) should work

  1. Buying an option bidding vol at X and selling that same option to someone else at vol X+Y, ceteris paribus. This is basically “brokering”, so the market maker makes money while limiting risk as it tries to hold the asset for the smaller amount of time possible. This adds value by offering a counterparty for the seller who was looking for a buyer and afterwards, for the buyer who was looking for a seller.
    The problem? It is not always so easy to have simoultaneusly 2 sides, plus there is a chance of making more money if you keep the asset in your book…if you embrace that risk.
  2. Buying an option bidding vol at X and hoping for the underlying to move past the breakeven point. This strategy can create good profits, the problem is that those profits are the result of a gamble…(I still haven’t met the guy who knows if ETH is going up or down in the next few days).
    The problem here is that the P&L of this strategy comes mainly from the underlying price in t0 and tn, as you are relying on a spot movement translating in an appreciation of the option (Delta unhedged). No one can control the underlying price in t0 and tn, so with this strategy the only way of having consistent chances of making money is bidding very low for the option, so that the breakeven is relatively close vs expected move of the underlying.
    Again, the problem there is that bidding super low doesn’t add much value for those in the market willing to sell. This strategy can be pretty much like a monkey driving a school bus, specially if the option pool is clearly skewed towards calls or puts.
  3. Buying an option bidding vol at X and managing this exposure, so that directional risk of underlying going up or down is limited, while the Realized Vol- Implied Vol (bid) spread can be monetized. This is a smart way of making money in a consistent way, taking risk but “embracing” and managing that risk. The big difference with 2. is that in this case, the P&L comes from the spread between Implied Vol in your bid and Realized Vol of the underlying until expiry (or secondary sale) of the option. The Implied Vol in your bid is directly controlled by you. With this strategy, you are long volatily: you want the underlying to realize as much volatility as possible. At the same time, you have your delta exposure mostly hedged.
    The problem? Realized vol could result to be lower than your expectations, even lower than the realized vol extrapolated from the Implied Vol in your bid. If that happens, you would have lost this game of “Realized- Implied Vol”.
LPs celebrating for profit after following strategy 2…they might crash few seconds after
European option Delta for several times to expiry
European option Gamma for several times to expiry
31 days to expiry, 2880 ETH Call GammaScalp simulation

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GammaHamma

GammaHamma

Ex-derivs sell-side @ IB. Derivs enthusiast. Crypto learner.