Author: @agintender
Why should a token borrowed by strength help you work well? What happened behind the scenes after the project handed over the token to the market maker? This article will reveal the core logic of algorithmic market making and analyze how market makers use your tokens to exchange for trading depth, price stability and market confidence.
Conclusion first: Due to the current lack of liquidity in the altcoin market, the best solution for market makers in the call option mode is to sell the tokens as soon as they are opened. Then you may ask, if you sell the tokens at the beginning, if the tokens rise again in the future, won’t the market maker have to spend a lot of money to buy them back?
reason:
1. The market maker’s strategy is delta neutral, and they don’t take positions. They just want to make a profit.
2. The call option actually limits the maximum price, which means it limits the maximum risk exposure of the MM (even if you soar 100 times, I can still buy it at 2 times the price)
3. This type of MM contract is for 12-24 months. With so many projects in the market now, most of them reach their peak as soon as they go online. How many of them can last until a year later?
4. Even if you survive 1-2 years and the price of the currency goes crazy, the profit from the price fluctuation will be enough to cover the loss of selling in advance.
introduction
The market has been good recently, and several of my friends’ projects want to hold TGE in the near future. Now they are stuck in choosing a “market maker”. They all asked me with the market maker’s terms, what do you think of these terms? What are the pitfalls? What will the market maker do when it gets our token? Will it really provide liquidity?
Especially seeing the report of movement: https://cn.cointelegraph.com/news/movement-network-binance-38-million-buyback
Disclaimer: The plot is purely fictional. Any similarity is purely coincidental.
If you think I'm wrong, then you're right
Entertainment statement: This article is written with the utmost "malice" and is not directed at anyone. Just read it for fun.
1. Market Background
Generally speaking, there are three common cooperation models for market makers:
- Renting a market making bot - the project party provides funds (token + stablecoin), the market maker provides "technical" and "personnel" support, and the market maker charges a retainer fee and (or) a profit sharing (if any).
- Active mm - The project party provides tokens (sometimes also some stablecoins), and the market maker provides funds (sometimes also does not provide stablecoins) to make markets and guide the community. The main purpose is to sell tokens. After the tokens are sold, the project party and the market maker share the profits in proportion.
- Call option (common) - The project provides tokens and the market maker provides funds (stable currency), but the market maker has a call option. When the price exceeds the agreed price, the market maker can exercise the option to purchase at a low price.
This article mainly explains the 3. call option model which is the most common in the market.
2. Market making terms of call option model
From the perspective of a delta neutral market maker, the following project cooperation terms are generally given (usually 12-24 months):
Note: This is purely fictional. If it looks familiar, then it is.
CeFi Market Making Obligations
Market makers need to provide liquidity for token ABC on the following exchanges:
- Binance: Within the price range of ±2%, place a buy order and a sell order worth 100,000 USD (i.e. you bear $100k USDT + $100k equivalent ABC). The bid-ask spread is controlled at 0.1%.
- Bybit and Bitget: Also within the range of ±2%, they each provide buy and sell orders of $50,000 USD (you need to invest $50k USDT + $50k equivalent ABC), and the spread is also controlled at 0.1%.
- DeFi market making obligations You need to provide a $1,000,000 liquidity pool for ABC on PancakeSwap, of which 50% is USDT and 50% is ABC tokens (i.e. $500k USDT + $500k ABC).
- The project provides resources. The project will lend you 3 million ABC tokens (2% of the total token supply, currently valued at $3M, meaning the FDV is $150M).
The current market price of ABC is $1/token.
The project gives you option incentives (European call options) If the market price of ABC token rises in the future, you can choose to exercise the option to purchase tokens. The specific terms are as follows: Strike Price (Strike) Quantity (ABC) Exercise Conditions $1.251 million If the market price > $1.25, you can buy $1.501 million If the market price > $1.50, you can buy $1.501 million If the market price > $2.00, you can buy $2.001 million If the market price > $2.00. If the market price does not reach the corresponding strike, you can choose not to exercise the option and do not assume any obligations.
Based on the above conditions, as a market maker that strictly implements the delta-neutral strategy, after obtaining these 3 million ABC tokens, how will it carry out the overall market making and hedging arrangements to ensure that it will not suffer losses due to token price fluctuations?
3. Think about it: If you were a market maker, what would you do?
3.1. Core objectives and principles
Always maintain Delta neutrality (this is the big premise): the net position (spot + perpetual contract + LP + option Delta) must always be close to zero to fully hedge the risk of market price fluctuations.
No directional risk: Profits should not depend on the increase or decrease in the price of ABC tokens.
Maximizing non-directional returns: Profits come from four core channels:
a. The bid-ask spread of a centralized exchange (CEX).
b. Transaction fees of decentralized exchange (DEX) liquidity pool (LP).
c. Gamma Scalping achieved by hedging over-the-counter options.
d. Potentially favorable funding rates.
3.2. Initial setup and decisive first step: hedging
This is the most critical step in the entire strategy. Actions are not determined by predicted prices, but by the assets received and obligations assumed.
3.2.1 Inventory of assets and obligations
Asset received (and also liability): 3,000,000 ABC tokens. This is a loan and we are obliged to repay 3,000,000 ABC tokens in the future.
Obligation deployment (inventory and funds):
- Binance Market Maker: 100,000 ABC (Sell Order) + 100,000 USDT (Buy Order) Bybit/Bitget Market Maker: 100,000 ABC (Sell Order) + 100,000 USDT (Buy Order) PancakeSwap LP: 500,000 ABC + 500,000 USDT
- Total market making inventory: 700,000 ABC Total USDT required for market making: 700,000 USDT
3.2.2 Calculation of initial net exposure (simple calculation version)
Note: Numbers are not important, logic is more important
If we only look at the token loan itself, holding 3 million ABC does perfectly hedge the obligation to repay 3 million ABC. However, as a market maker, we cannot just look at the loan, we must look at the net position of the entire business.
USDT funding gap: Market making obligations require at least 700,000 USDT to provide buy order liquidity immediately. Where does this money come from? The most direct, most consistent with the spirit of the agreement, and in line with the current market where new coins peak at the opening, is to obtain it by selling part of the borrowed ABC tokens.
ABC that must be sold to obtain USDT: In order to obtain 700,000 USDT, at the current price of $1, at least 700,000 ABC must be sold. (Generally, it will be sold in the "initial liquidity window" or OTC. Conscientious mm will usually open a long position to hedge)
Recalculate the net exposure: Initially there are 3 million ABC.
Use 700,000 ABC as sell order inventory for CEX and DEX.
At this point, the remaining ABC in hand is: 3,000,000 - 700,000 (inventory) - 700,000 (sold for USDT) = 1,600,000 ABC. Now, these 1.6 million ABC are the real net long exposure (Net Long Delta). We no longer have a funding gap in USDT, but the 1.6 million tokens we hold have no hedge, and if the price falls, we will face losses.
3.2.3 Initial hedging operations: answering the question “When to sell?”
The answer is: sell immediately. The amount sold is precisely calculated to achieve two goals: 1) obtain the USDT required for operations; 2) hedge the remaining token exposure.
Action: As soon as market making starts, our automated trading system will immediately sell a total of 2,300,000 ABC on the market. 700,000 ABC is to exchange for the 700,000 USDT required for market making. The other 1,600,000 ABC is to hedge the remaining unhedged token positions in our hands.
how so:
Satisfy operational needs: This move provides us with the necessary USD liquidity to meet all market making obligations. Achieve true Delta Neutral: After selling all 2.3 million ABC, we no longer have any unhedged ABC token exposure. Our risk is completely neutral. Lock in risk: We completely transfer the risk of price fluctuations and focus only on profiting from market making and volatility.
We do not hold any “naked” ABC tokens waiting for the price to rise. Every token position, whether positive or negative, must be precisely hedged.
3.3. Dynamic hedging: 24/7 risk management
Once the initial hedging is completed, our risk exposure will continue to change due to market making activities and market changes, requiring continuous dynamic hedging.
- CEX Market Making Hedging: When our buy order is executed, we will buy ABC (generating a long Delta), and the system will immediately short an equal amount of ABC in the perpetual contract market. And vice versa. In this way, we earn a 0.1% spread while maintaining Delta neutrality.
- DEX LP hedging: The 500,000 ABC inventory in PancakeSwap is subject to impermanent loss risk, which is essentially a short Gamma position. Our model continuously calculates the Delta of LP (negative when the price rises, positive when it falls) and uses perpetual contracts for reverse hedging.
3.4. Option strategies: the real profit engine
This is the most subtle part of the entire transaction and the key to our ability to go beyond simple market makers and achieve excess profits.
3.4.1 Understanding the Value of Options
What we have is not a token, but a right. This right (three-level call option) has positive Delta and positive Gamma. This means:
- Positive Delta: As prices rise, the option value increases.
- Positive Gamma: The more drastic the price change, the faster Delta changes, which is more favorable to us.
3.4.2 Hedging options instead of holding tokens
We don't simply wait for the price to reach $1.25, 1.50 or 2.00. We hedge the option's delta.
Initial Hedge: Use an option pricing model (such as Black-Scholes) to calculate the total Delta of these three options at the current price of $1.00. Assume the result is +400,000. To maintain neutrality, we must short an additional 400,000 ABC in the perpetual contract market. (The larger the option, the more shorting is needed)
Gamma Scalping: This is the dynamic answer to “when to buy and sell”.
Scenario 1: Price rises from 1.00 to 1.10 The option's Delta will increase (because it is closer to the strike price), for example, from +400,000 to +550,000.
Our net position is no longer 0, but a long exposure of +150,000. Action: Our system will automatically sell 150,000 ABC perpetual contracts to regain neutrality. Scenario 2: The price drops from 1.10 to 1.05. The Delta of the option will decrease, for example, from +550,000 to +500,000.
Our existing short hedge position is now “too much”, creating a net short exposure of -50,000. Action: Our system will automatically buy 50,000 ABC perpetual contracts to cover the position, achieving neutrality again.
Isn't it amazing?! Through hedging, we can naturally achieve "sell high and buy low". This process is repeated continuously, and we "strip" profits from every fluctuation of the market. This is Gamma Scalping. We make money from volatility, not direction.
3.4.3 Operations near the strike price
When the price approaches and exceeds $1.25: Our first option becomes In-the-Money. Its Delta will quickly approach 1 (1 million).
Our hedge short position will also increase accordingly to nearly 1 million ABC. Exercise decision: At option expiration, if the price is above $1.25, we will exercise the option. Action: Pay $1,250,000 USDT to the project party and receive 1,000,000 ABC tokens. Immediately sell these 1 million ABC tokens in the spot market. At the same time, close the 1 million ABC perpetual contract short position we established to hedge this part of the option. Profit: The profit comes from the difference between the strike price and the market price, as well as the accumulated income of Gamma Scalping throughout the process.
For strike prices of 1.50 and 2.00, the logic is exactly the same. We are not betting on whether the price can be reached, but we can continue to profit by dynamically adjusting the hedge position when the price fluctuates, and execute the strike arbitrage risk-free when the price is indeed reached.
3.5. Conclusion and operational recommendations
Initial Token Processing: 2.3 million ABC tokens will be sold immediately, of which 700,000 will be used to obtain operational USDT and 1.6 million will be used to hedge the remaining positions. No unhedged token positions will be held at all times.
Price < $1.25: Do not actively buy or sell any non-hedging ABC. Continue to make CEX market, DEX LP hedging and option gamma scalping. Profits come from spreads, fees and volatility.
Price > $1.25 (and subsequent strike prices): When the price is significantly higher than the strike price, our hedging engine has already established a corresponding short position for us. Exercise becomes a risk-free delivery process: buy tokens from the project at a low price, immediately sell them at a high price in the market, and close the hedge position at the same time.
This strategy breaks down a seemingly complex market-making agreement into a series of quantifiable, hedgeable, and profitable risk-neutral operations. The success of a market maker does not depend on market forecasts, but on excellent risk management capabilities and technical execution.
After reading this, I hope you can understand that it is not that the market maker has a problem with you and is “deliberately” dumping the market? Rather, under this mechanism and algorithm, “selling” tokens and opening a short position at the beginning is the local optimal solution of the market making strategy.
It's not that he is bad, but it is a rational choice after weighing the pros and cons.
The market is cruel. The better the deal seems, and the less risky it seems, the more likely it is that it is the result of precise calculations.
When you can't see the risk points, you are the risk point.
May we always remain in awe of market algorithms.
