Building an Options Market: Volatility, Price Discovery, and Two-Way Flow

# Options market making process (step-by-step)


# Options market making process (step-by-step)












What are the steps involved in options market making?

Does it roughly follow this procedure:

- Choose a pricing model, e.g. Black-Scholes.

- Calibrate the model, e.g. Volatility.

- Quote a bid-ask spread for the option.

- Trade (which results in a net long/short position).

- Compute the Greeks to hedge the position.

- Repeat.

It seems to me that an important remaining factor would be forecasting volatility once the position is delta hedged?

Thank you in advance!

## Answer by user35980 (score 6, accepted)

https://quant.stackexchange.com/a/76626

It's not clear from the question, but there are two scenarios:

1/ you have an actively traded and well-established options market in which you're going to get involved as a new participant and take on risk;

2/ you're establishing a new options market which is either non-existent or very illiquid.

In 1/ all you're really doing is providing liquidity. The more interesting question is referring to 2/. The steps you describe (with the exception of 3.) are in a sense posteriori. So if your question was only related to 1/ you can stop reading here! Btw model choice is relevant to the product being quoted. Let's stick to vanilla options (so just Black-Scholes).

In 2/ the key objectives are to understand the liquidity/flow of the underlying and analyze its historical realized volatility. This allows one to get a sense of where implied volatility, if it existed, may be. Next, some idea of the term structure of the vols is necessary i.e. how the vols vary with expiry. This is usually followed by price discovery (done in an inter-dealer setting showing out vanilla price runs), establishing demand/supply, open interest from prospective clients... etc. All of this derives from the dynamics of the underlying that you intend to quote the options on, as this is the only data you have to work with. Having a proxy market for options in another underlying which is strongly correlated to the one you intend to establish your new options market on is also very useful. Particularly to get an idea of a realized/implied vol spread (implieds usually trade over).

Market-making (as described above) is not exact science and is driven by necessity (demand/supply). This sometimes has an unfortunate side-effect in many younger options markets being very one sided (e.g. bid only). This is a huge drawback as things never really get off the ground and the market just dies. Having two-way flow is essential to the survival of a market.

Finally, options market-makers don't "forecast volatility": I'm not sure how one would even go about doing that. There is a notion of forward volatility which can be deduced from the term structure of the current spot volatilities. But this is in itself a separate market which has its own dynamics. The dynamics of the spot vols are driven by how much the underlying delivers as a well as demand/supply, and market-makers adjust their quotes primarily in accordance with these factors.

Edit: I should mention that all of the above discussion is only with respect to ATM vols. Establishing skew and off-strike vols is a whole other world of hurt, which I'll leave for another day.

## Answer by Mina Shiri (score 0)

https://quant.stackexchange.com/a/80548

Thanks for the question and complete answer you two provided. I have some simple questions because they made it hard for me to understand the text compeletely. first of all, what do you mean by "vols"? does it reffer to volatility?