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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.

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2 Answers 2

up vote 7 down vote accepted

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.

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Purely because of the detail of the answer ,I would love to give more "ups" to you. technically, I have been trading quantitatively in "linear" assets- like stocks,indices, currencies etc, using quantitative strategies. Options I must say, is something I couldnt really get a handle on. So yes, I am very naive in Option Mathematics (I do know BS derivation, but nothing beyond that), and ignorant and illiterate in option trading.@Sheegaon many thanks for giving me some good pointers. –  Soham Jul 27 '11 at 4:17

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

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What a sexy document! I actually understood most of it, on the first read :) (plus nice advice, especially about the sheep part) Now I am not sure, whose answer to tick? :) –  Soham Jul 27 '11 at 4:31
I ticked your answer, purely because the link directly gave me an idea into what I am looking at.@SheGaon reco will take me to the next level for sure –  Soham Jul 27 '11 at 4:32
@Soham if you are seriously interested in dispersion trading, you can do worse than Bossu's papers –  Tal Fishman Jul 27 '11 at 14:11
@sheegaon Worse than Bossu's papers? I am not sure, I get it –  Soham Jul 28 '11 at 10:06
@Soham, lucky for you, this has already been answered on English Stack Exchange! I just meant that I wouldn't trust the "guide" posted above. It looks riddled with errors and is sloppily written. –  Tal Fishman Jul 29 '11 at 18:29

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