Option Market-Maker Inventory Risk and Calendar-Spread Hedges

Summary

The document considers whether an option market maker might hedge large positions by buying longer-dated options. One response questions that example: short-dated options are often more liquid and tighter, so they may be more practical instruments for hedging longer-dated exposure than the reverse. It suggests the author may have meant offsetting gamma or vega risk against incoming customer flow, rather than actively hedging by crossing the spread. This explanation is tentative and is not supported with cited literature.

A second response emphasizes inventory risk: a market maker remains exposed between buying and selling, and holding inventory creates market risk. It suggests calendar spreads can reduce directional exposure while leaving room for profit. The discussion is brief and does not specify hedge ratios, option sensitivities, market conditions, or empirical evidence. Its observations are therefore useful as hypotheses about liquidity and inventory management, not as a detailed or universally applicable hedging rule.

Key ideas

• Market makers face inventory risk while positions remain open between trades.
• Short-dated options may be more liquid and cheaper to trade than longer-dated options.
• A calendar spread can offset some exposure while preserving potential trading profit.
• Buying longer-dated options to hedge short-dated inventory may refer to offsetting gamma or vega against order flow.
• The proposed explanations are tentative and do not establish a general hedging practice.

Tags

# Option Market Making: Hedging large volumes


# Option Market Making: Hedging large volumes












In the book McMillian on Options the author states that in some cases an option market maker hedges himself by purchasing longer dated options. Unfortunately, the author does not go into detail why the market maker does that. I was unable to find on the internet literature that this is actually true. I was wondering if someone could confirm this and explain why this is the case?

Edit: Rephrased the question.

## Answer by onlyvix.blogspot.com (score 1, accepted)

https://quant.stackexchange.com/a/35270

McMillian's example does not make sense to me. Typically short-dated contracts are liquid and longer expirations are less so, and it would make sense to hedge long-expirations contracts with more liquid (also typically tighter, and more leveraged) short-term ones, but not the other way around.

The only explanation for this, is maybe by "hedging" he meant just laying off gamma/vega risks against flow, and not (what I would call) actively hedging by crossing the spread.

Source: I'm a former OMM. Don't know any literature that describes things like that.

## Answer by yety (score 0)

https://quant.stackexchange.com/a/35265

Toughest challenge you face as a market maker is inventory risk. To sell something, you should own it. Time between buy and sell is never zero and you have same exposure against market as any other participant.

Taking advantage of calendar spread makes you market neutral, but you still have place for profit.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

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