Author: @agintender
Why should we help you do work when we borrow tokens based on our strength? After the project team hands over the tokens to the market makers, what exactly happens behind the scenes? This article will unveil the core logic of algorithmic market making and analyze how market makers use your tokens to obtain trading depth, price stability, and market confidence.
First, the conclusion: Due to the current lack of liquidity in altcoins, under the call option model, the optimal solution for market makers is to sell the project team's tokens immediately after obtaining them. Then you might ask, if they sell the tokens right away, assuming the tokens rise later, wouldn't the market maker need a lot of money to buy them back?
Reason:
1. The strategy of market makers is to maintain delta neutrality without taking positions—what they seek is to guarantee profits without losses.
2. Call options actually restrict the maximum price, limiting the market maker's maximum risk exposure (even if you skyrocket by 100 times, I can still buy at 2 times the price).
3. This type of market maker contract is typically 12-24 months; considering there are so many projects in the market now, how many can survive until a year later?
4. Even if we endure for 1-2 years and the token price skyrockets, the profits from price fluctuations will be sufficient to cover the losses incurred from selling early.
Introduction.
Recently, the market has been doing well, and several friends' projects are looking to TGE soon. They are currently stuck on the choice of 'market makers.' They all ask me about the terms of market makers, how do you think these conditions are? Are there any pitfalls? What will market makers do with our tokens? Will they really provide liquidity?
Especially upon seeing the movement report: https://cn.cointelegraph.com/news/movement-network-binance-38-million-buyback.
Disclaimer: The plot is purely fictional; if there is any resemblance, it is coincidental.
Leverage Disclaimer: If you think I'm wrong, then you are right.
Entertainment Disclaimer: This article is written with the greatest 'malice,' not aimed at anyone; just get a general idea and have some fun.
1. Market Background.
In general, there are three common collaboration models for market makers.
Renting market-making bots - the project team provides funding (tokens + stablecoins), market makers provide 'technical' and 'personnel' support, and the market maker receives a retainer fee and/or profit sharing (if any).
Active market makers - the project team provides tokens (sometimes also a bit of stablecoins), and market makers provide funding (sometimes not providing stablecoins) for market making and community guidance, primarily aiming to sell tokens. After selling the tokens, the project team shares the profits with the market makers proportionally.
Call option (common) - the project team provides tokens, and market makers provide funding (stablecoins), but market makers have a call option; if the price exceeds the agreed price, the market maker can exercise and buy at a low price.
This article mainly explains the most common 3. call option model.
2. Market making terms for call option model.
From the perspective of a delta-neutral market maker, generally, the following project cooperation terms will be given (usually 12-24 months):
Note: Purely fictional; if it seems familiar, that's purely coincidental.
CeFi Market Making Obligations.
Market makers need to provide liquidity for token ABC on the following exchanges:
Binance: Place buy and sell orders worth $100,000 each within a ±2% price range (i.e., you bear $100k USDT + $100k equivalent in ABC). Control the bid-ask spread (spread) at 0.1%.
Bybit and Bitget: Similarly provide buy and sell orders worth $50,000 each within a ±2% range (you need to invest $50k USDT + $50k equivalent in ABC), with the spread also controlled at 0.1%.
DeFi Market Making Obligations: You need to provide a liquidity pool of $1,000,000 for ABC on PancakeSwap, with 50% in USDT and 50% in ABC tokens (i.e., $500k USDT + $500k ABC).
The project team provides resources: The project team will lend you 3 million ABC tokens (i.e., 2% of the total token supply, currently valued at $3M, which implies an FDV of $150M).
The current market price of ABC is $1/token.
Option incentives provided to you by the project team (European call options) If the market price of the ABC token rises in the future, you may choose to exercise your right to purchase tokens under the following terms: Exercise Price (Strike) Quantity (ABC) Exercise Conditions $1.25100,000 If the market price > $1.25, you can buy at $1.25 $1.50100,000 If the market price > $1.50, you can buy at $1.50 $2.00100,000 If the market price > $2.00, you can buy at $2.00. If the market price does not reach the corresponding strike, you may choose not to exercise, incurring no obligations.
Based on the above conditions, as a market maker strictly implementing a delta-neutral strategy, after obtaining these 3 million ABC tokens, how will they arrange overall market making and hedging to ensure they do not incur losses due to token price fluctuations?
3. Reflection: If you were a market maker, what would you do?
3.1. Core Goals and Principles.
Always maintain delta neutrality (this is the major premise): The net position (spot + perpetual contracts + LP + options delta) must always be close to zero to fully hedge the risk of market price fluctuations.
Do not bear directional risks: Profits should not rely on the rise or fall of ABC token prices.
Maximize non-directional profits: profits come from four core channels:
a. The bid-ask spread on centralized exchanges (CEX).
b. Trading fees from decentralized exchange (DEX) liquidity pools (LP).
c. Volatility arbitrage (Gamma Scalping) achieved through hedging OTC 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 price predictions but by the assets received and obligations undertaken.
3.2.1 Inventory of Assets and Obligations.
Received Assets (which are also liabilities): 3,000,000 ABC tokens. This is a loan, and we are obligated to repay 3,000,000 ABC tokens in the future.
Obligation Deployment (Inventory and Capital):
Binance Market Making: 100,000 ABC (sell order) + 100,000 USDT (buy order) Bybit/Bitget Market Making: 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 Initial Net Exposure Calculation (Simple Calculation Version).
Note: Numbers don't matter; logic is more important.
If we only look at the token loan itself, holding 3 million ABC perfectly hedges the obligation to repay 3 million ABC. However, as a market maker, we cannot look at the loan in isolation; we must consider the net position of the entire business.
USDT funding gap: Market-making obligations require us to immediately outlay at least 700,000 USDT to provide buy order liquidity. Where does this money come from? The most direct, protocol-compliant, and market-consistent way, given that many new tokens peak immediately upon listing, is to acquire it by selling part of the borrowed ABC tokens.
To obtain USDT, ABC must be sold: To obtain 700,000 USDT at the current price of $1, at least 700,000 ABC must be sold. (This is usually done in the 'initial liquidity window' or OTC; a conscientious market maker might also open a long position to hedge.)
Recalculate Net Exposure: Initially, there are 3 million ABC.
Used 700,000 ABC as CEX and DEX sell order inventory.
At this point, the remaining ABC is: 3,000,000 - 700,000 (inventory) - 700,000 (sold for USDT) = 1,600,000 ABC. Now, these 1.6 million ABC are the true net long exposure (Net Long Delta). We no longer have a USDT funding gap, but the 1.6 million tokens we hold are not hedged, and if the price drops, we will face losses.
3.2.3 Initial Hedging Operation: Answer 'when to sell?'
The answer is: sell immediately. The quantity sold is precisely calculated to achieve two goals: 1) Obtain the USDT needed for operations; 2) Hedge the remaining token exposure.
Action: At the very start of market making, our automated trading system will immediately sell a total of 2,300,000 ABC in the market. Among them, 700,000 ABC is to acquire the 700,000 USDT needed for market making. Additionally, 1,600,000 ABC is to hedge our remaining unhedged token positions.
Why so:
Meeting operational needs: This provides us with the necessary US dollar liquidity to fulfill all market-making obligations. Achieving true delta neutrality: After selling all 2.3 million ABC, we no longer have any unhedged ABC token exposure. Our risk is completely neutralized. Locking in risk: We fully transfer the risk of price fluctuations and only focus on profiting from market making and volatility.
We will not hold any 'naked' ABC tokens waiting for the price to rise. Every token position, whether long or short, must be accurately hedged.
3.3. Dynamic Hedging: 7x24 hours of risk management.
After the initial hedging is completed, our risk exposure will constantly change due to market-making activities and market fluctuations, requiring continuous dynamic hedging.
CEX Market Making Hedge: When our buy orders are executed, we will buy ABC (creating long delta), and the system will immediately short an equivalent amount of ABC in the perpetual contract market. And vice versa. We earn a 0.1% spread in this manner while maintaining delta neutrality.
DEX LP Hedging: The 500,000 ABC inventory in PancakeSwap carries the risk of impermanent loss, which is essentially a short gamma position. Our model continuously calculates the LP's delta (negative when prices go up, positive when they go down) and hedges it in the opposite direction using perpetual contracts.
3.4. Options Strategy: The Real Profit Engine.
This is the most exquisite part of the entire transaction and the key to our exceeding simple market making and achieving excess profits.
3.4.1 Understanding the Value of Options.
What we hold is not tokens but a right. This right (three call options) has positive delta and positive gamma. This means:
Positive Delta: Price increases, option value increases.
Positive Gamma: The more volatile the price changes, the faster the delta changes, which is more beneficial for us.
3.4.2 Hedge options, not hold tokens.
We will not simply wait for the price to reach $1.25, $1.50, or $2.00. We will hedge the delta of the options.
Initial Hedging: Use an options pricing model (like Black-Scholes) to calculate the total delta of these three options at the current price of $1.00. Assume it calculates to +400,000. To maintain neutrality, we must short an additional 400,000 ABC in the perpetual contract market. (The larger the option, the more we need to short.)
Gamma Scalping: This is the dynamic answer to 'when to buy and sell.'
Scenario 1: The price rises from 1.00 to 1.10, the delta of the options 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 has 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 options will decrease, for example, from +550,000 to +500,000.
Our existing short hedged position is 'excessive,' creating a net short exposure of -50,000. Action: Our system will automatically buy 50,000 ABC perpetual contracts to replenish and regain neutrality.
Isn't it amazing?! Through hedging, we naturally achieve 'high selling and low buying.' This process repeats continuously, and we 'extract' profits from every market fluctuation, this is gamma scalping. We earn money from volatility, not from direction.
3.4.3 Operations near the exercise price.
When the price approaches and exceeds $1.25: Our first options become in-the-money (ITM). Their delta will quickly approach 1 (1 million).
Our hedged short position will also increase to close to 1 million ABC. Exercise decision: At the expiration of the options, if the price is above $1.25, we will exercise. Action: Pay $1,250,000 USDT to the project team and receive 1,000,000 ABC tokens. Immediately sell these 1 million ABC tokens in the spot market. Simultaneously close out the 1 million ABC perpetual contract short position we established to hedge this portion of the options. Profit: The profit comes from the difference between the exercise price and the market price, as well as the accumulated gains from gamma scalping throughout the process.
For exercise prices of 1.50 and 2.00, the logic is exactly the same. We are not betting on whether the price will reach; rather, we profit continuously by dynamically adjusting the hedge position during price fluctuations and execute risk-free exercise arbitrage when the price actually reaches.
3.5. Conclusion and Operational Recommendations.
Initial Token Handling: Immediately sell 2.3 million ABC tokens, of which 700,000 are used to acquire operational USDT, and 1.6 million are used to hedge the remaining position. Never hold any unhedged token positions.
Price < $1.25: Do not actively buy or sell any non-hedged ABC. Continuously engage in CEX market making, DEX LP hedging, and options gamma scalping. Profits come from spreads, fees, and volatility.
Price > $1.25 (and subsequent exercise prices): When the price is significantly higher than the exercise price, our hedging engine has already established corresponding short positions for us. Exercising becomes a risk-free delivery process: buy tokens from the project team at a low price and immediately sell them at a high price in the market while closing the hedge position.
This strategy breaks down a seemingly complex market-making protocol into a series of quantifiable, hedgeable, and profitable risk-neutral operations. The success of market makers does not depend on market forecasting but rather on excellent risk management capabilities and technical execution.
After reading this, I hope you understand that it’s not that the market makers have an opinion about you, 'intentionally' crashing the market? Rather, under this mechanism and algorithm, initially 'selling' tokens and opening a short position is a locally optimal solution of the market-making strategy.
It’s not that they are bad, but rather a rational choice after weighing the pros and cons.
The market is brutal; deals that seem good and low-risk are often the result of precise calculations.
When you cannot clearly see the risk points, you are the risk point.
May we always maintain a heart of reverence for market algorithms.
