Tutorial #2 – Option market making : start learning to make option prices in Volcube

In Volcube trading simulations, you take on the role of an options market maker. Learning to make markets in options is a great way to learn about options trading generally. If you can successfully trade and manage an options portfolio in Volcube, you will be well on the way to understanding options like a professional options trader.

So what is an options market maker? An options market maker is someone who is prepared to show two-way prices in options. This means they are always ready to show a price at which they will buy AND sell an option or package of options. In Volcube, the broker will ask you for price quotations in various options on an imaginary underlying product. You will have respond with a price you are prepared to pay (your ‘bid price’) and a price at which you are prepared to sell (your ‘ask price’). The broker will then respond with an order. He may decide to ‘hit’ your bid (i.e. to sell you the options) or he may decide to ‘lift’ your offer (i.e. to buy the options from you at your ask price). Or he may decide to show you an order at a price that is in between your bid and ask prices. You will either then have to trade if the broker is trading on your price or you may have the option as to whether to trade if the broker is just showing you an order. You need to make your decision based on whether you think the order represents a good trade. Is the broker paying too much? Does the trade make your existing position more or less risky? Are you selling these options at the same price as you just sold lots of other options? And you need to be quick! The broker won’t wait all day for you to make a decision! But don’t worry if this seems a lot to take in. It will all become clear as you play on Volcube.

So where should you start? Go to the Game tab in the Volcube application and choose to play either a Levels game or a Custom game. Once you have started the mock trading session, you should see the Main Game screen. If you haven’t already checked out this short video on the Main Game screen, you might want to do that either now or at the end of this tutorial. Let’s focus on the Messenger pane in the top right. You should see the broker saying something like “JUN 101 puts?”. This means the broker is requesting a quote from you in the June expiry, 101 strike puts.  Just below the white conversation area, you can see some information. The strategy being quoted (in this case, the JUN 101 puts) and then some numbers labelled, Theo, Delta and Vega. These tell you the theoretical value, the delta and the vega of the option strategy being quoted by the broker. You can find the same information using the Pricing Sheet to the left of the Messenger pane. Anyway, this tells us that the JUN 101 puts are theoretically (i.e. according to our pricing model) worth $3.694. So we need to make a two-price for the broker. Let’s assume for now that our theoretical value is reliable and that these put options are really worth what the model says. What prices should we show? Well, the aim here is to make a profit so ideally we want to buy the puts for less than the theoretical value and sell them for more than their value. Using the up/down arrow buttons we can adjust our price to reflect this. Let’s show something like a 3.65 bid and a 3.73 ask price. So this means if the broker tries to sell these puts to us, we will pay $3.65. If he comes in to ‘lift our offer’ he will be buying the puts and paying $3.73. Either way, we will make a theoretical profit relative to the theoretical value. If you buy something for less than its value or sell it for more than its value, you make a profit!

We also need to add two quantities to our bid and ask prices. These quantities reflect the minimum quantities we are prepared to trade on the prices we are showing. So showing bid and ask quantities of 100 means the broker can rely on us to trade at least 100 lots on these prices.

In the next graphic on the left, you can see I have entered my quote response by hitting the QUOTE button after I had adjusted my bid and ask prices. The broker has responded by showing a bid i.e. he wants to buy the puts. The broker wants to pay 3.72 for 200 lots of the puts. This is very close to my ask price of 3.73. So now we have to decide whether to trade any or some or all of this broker order. We use the number pad to select the quantity we want to trade and hit DONE. Or we can hit the PASS button on this occasion as we are not obligated to trade (because the broker is not hitting our bid or lifting our offer; he is showing an order at a price in between our quoted price). Press the ‘C’ button to clear your quantity in case you change your mind.

If we spend too long thinking about whether or not to trade, then we may miss the order. Sometimes the broker will trade the order with an artificial competing market maker. But remember, not all broker orders are good trading opportunities! One of the skills you will learn with Volcube is whether a broker order is good or bad, both in terms of your position and in terms of the market order flow in general.

If you execute a trade, then you should see the trade enter your TradeLog (in the top right of the Main Game screen) as well as your Inventory (bottom left of Main Game screen). Your Risk Detail and Risk Limits should also update to reflect your real-time risk. You should also notice that unless you have disabled the feature in the Custom Play setup, then Volcube will have delta-hedged your option trade. You can see this in the TradeLog where your option trade should be accompanied by a 2nd trade in the SPOT product. You can learn a lot more about delta hedging in the Blitz Video section and the Option Theory articles in the Learning environment.

This tutorial should allow you to start entering option prices in Volcube. In the next tutorial you will learn the basics of option risk management in Volcube.

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