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Managing Risk in Illiquid Single-Stock Option Market Making

Article Quant Q&A · Author: Soham
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Summary

The document discusses quantitative research and risk management for making markets in illiquid single-stock options. It recommends learning option Greeks and building tools to monitor exposures in real time. For hedging, it cautions that index options may be a poor proxy for options on individual index constituents. The proposed approach is to hedge first with the underlying and with other, more liquid options on the same stock, then manage any remaining exposure through the underlying.

The answer also points readers to books on option trading and volatility trading, describing information-based market making that uses a Kalman filter to update an estimate of value. As an introductory quoting technique, it mentions copying prices from an apparently competent market participant to stay near prevailing quotes and collect spread. This is presented as a limited starting point: it does not adequately manage inventory and may create difficulties near expiration. The response is advice and references, not empirical evidence that the suggested methods are profitable.

Key ideas

  • Real-time monitoring of option Greeks is a practical starting point for market-making research.
  • Index options may not hedge the risk of single-stock options closely.
  • Hedging can use the same stock and options on that stock before addressing residual exposure.
  • Kalman filtering can help update value estimates in information-based market making.
  • Mirroring another trader's quotes may keep prices near the market but does not control inventory risk.

Tags

OptionsMarket makingRisk managementExecution
Full text
# How can I learn about the quantitative aspects of market making in illiquid single stock options?


# How can I learn about the quantitative aspects of market making in illiquid single stock options?












I would like to learn more about the possible ways of doing quantitative research regarding option market making. In particular, while the mainstream index option market may be very liquid, the single stock option market is highly illiquid. I would like to research market making in single stock options while making use of greater liquidity in index options.

Additionally, I would love to read a few books which cover the quant aspects of option market making more generally.

## Answer by Tal Fishman (score 13, accepted)

https://quant.stackexchange.com/a/1516

A good place to start learning about option market making using quantitative techniques is Euan Sinclair's Option Trading (chapter 10 is devoted to market making techniques). He also gives a decent introduction to a more sophisticated quantitative market making technique which he calls information-based market making. Specifically, he explains how to apply Kalman filtering to optimally incorporate new information into an estimate of value.

Sinclair's Volatility Trading is also a good reference for options, but more geared towards aggressive strategies that attempt to predict where the market is headed.

As for your actual question regarding market making in illiquid markets, I believe your best bet is to learn all the Greeks well and try to create tools to manage them in real time. Your question suggests that you would like to hedge your individual equity options with index options. Index options are generally a very poor hedge for the options on the constituents of the index. Rather, most market makers dynamically hedge by trading the underlying and by trading other options contracts on the same underlying (different strikes/maturities) that may be more liquid. Remember that, at least in theory, an option can be perfectly hedged by dynamically trading the underlying. In practice, due to the risk of jumps in the underlying and to hedge higher order Greeks, market makers attempt to hedge using other options (in the same underlying) first, and then hedge the residual exposure by trading in the underlying.

A good way to start learning, as Sinclair writes, is mimicry:

> If a trader has no clue where to quote a market, a good trick is to identify a competent trader and post the same prices as him. The identification of the “competent” trader is not actually crucial either. This trick works purely because it keeps the trader on the general market and hence collecting the bid-ask spread. And as we saw in the Chapter on volatility trading, even hedging these trades at the current implied volatility gives as good a result as anything else. This method is good for generating revenue, however it is poor for inventory management and traders using it will find themselves with problems as they approach expiration.

## Answer by user508 (score 7)

https://quant.stackexchange.com/a/1517

For single stock options against index options, this may be of interest: Dispersion -- A Guide for the clueless

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.