Unveiling the Core Logic of Algorithmic Market Making

What happens behind the scenes after the project party hands over the tokens to the market maker? This article will delve into the operational mechanism of Algorithm market making, analyzing how market makers use the project party’s tokens to provide trading depth, stabilize prices, and enhance market confidence.

Market Status

Currently, the liquidity of altcoins is severely insufficient. Under the call option model, the optimal strategy for market makers is often to sell off the tokens immediately after obtaining them from the project team. This practice may raise questions: If the token price rises in the future, won’t market makers have to spend a large amount of money to buy them back?

In fact, the reasons why market makers adopt this strategy are as follows:

1. Market makers implement a delta-neutral strategy, do not hold positions, and aim for stable profits.

2. The call option has set a maximum price cap, limiting the market maker’s maximum risk exposure.

3. Most market-making contracts have a term of 12-24 months. Considering the performance of many projects in the current market, there are not many that can last more than a year.

4. Even if the project’s price surges in 1-2 years, the profits from price fluctuations are enough to offset the losses incurred from selling too early.

Common Market Making Cooperation Models

There are mainly three types of market maker cooperation models in the market:

1. Renting market-making robots: The project party provides funds in ( tokens and stablecoins ), while the market makers provide technical and personnel support, charging a fixed fee and potential profit sharing.

2. Proactive market making: The project party provides the token ( and sometimes a small amount of stablecoin ), while the market makers provide funds for market making and guide the community, with the main goal of selling tokens, and both parties share the profits in proportion.

3. Bull Call Option Model: The project party provides tokens, the market maker provides stablecoin funds, and simultaneously obtains a call option, which can be exercised to purchase at a low price when the price exceeds the agreed level.

This article will focus on the most common bullish options patterns in the market.

Typical Terms of Call Option Model

From the perspective of delta-neutral market makers, the following cooperation terms are generally proposed: ( is usually for a duration of 12-24 months ):

Centralized Exchange ( CEX ) Market Making Obligation:

• On a large trading platform, provide buy and sell orders worth $100,000 within a ±2% price range, with a spread controlled at 0.1%.
• On the other two trading platforms, similarly providing buy and sell orders valued at $50,000 within a ±2% range, with a spread also controlled at 0.1%.

Decentralized Exchange ( DEX ) market-making obligations:

• Provide a liquidity pool of 1 million USD for a token on a certain DEX, with 50% in USDT and 50% in the project token.

Project team provides resources:

• Lending 3 million tokens ( to market makers accounts for 2% of the total supply, with a current valuation of 3 million USD and a fully diluted market cap of 150 million USD ).

The current market price of the token is 1 dollar.

The options incentive provided by the project party ( European call option ):

• If the future token price rises, the market maker can choose to exercise the option to buy the tokens, with the specific terms as follows:
  • When the market price > $1.25, you can buy 100,000 pieces at $1.25.
  • When the market price > 1.50 USD, you can buy 100,000 pieces for 1.50 USD.
  • When the market price > 2.00 USD, you can buy 100,000 pieces at 2.00 USD.

If the market price does not reach the corresponding exercise price, the market maker can choose not to exercise and will not bear any obligations.

Market Maker’s Strategy Analysis

Core Objectives and Principles

1. Always maintain Delta neutrality: Net position ( Spot + perpetual contracts + LP + options Delta ) must always be close to zero, fully hedging market price volatility risk.

2. No directional risk: Profit does not depend on the rise and fall of token prices.

3. Maximize non-directional returns: Profit sources include the spread between CEX buy and sell prices, transaction fees from DEX liquidity pool trades, volatility arbitrage realized from hedging OTC options, and potential favorable funding rates.

Initial Setup and Key First Step: Hedging

This is the most critical step in the entire strategy, where actions are determined by the assets received and the obligations undertaken, rather than price predictions.

Asset and Liability Inventory:

• Received 3 million tokens ( which is also a liability )
• Market-making obligation deployment: requires 700,000 tokens and 700,000 USDT

Initial Net Exposure Calculation:

• Initially holding 3 million tokens
• Used 700,000 pieces as inventory for CEX and DEX sell orders
• Need to sell 700,000 pieces to exchange for 700,000 USDT for buying orders.
• The remaining 1.6 million coins are true net long positions.

Initial hedge operation:

• Immediately sell a total of 2.3 million tokens
• Among them, 700,000 coins are used to exchange for the USDT required for market making.
• An additional 1.6 million coins are used to hedge the remaining positions.

Doing so can meet operational needs, achieve true Delta neutrality, and lock in risks.

Dynamic Hedging: All-Weather Risk Management

After the initial hedging, the risk exposure will continuously change due to market making activities and market fluctuations, requiring ongoing dynamic hedging:

• CEX market making hedge: When a buy order is executed, immediately short the equivalent amount of tokens in the perpetual contract market, and vice versa.
• DEX LP Hedging: Continuously calculate the Delta of LP and hedge in the opposite direction using perpetual contracts.

Options Strategy: Core Profit Source

Options strategies are the most intricate part of the entire trading process and are key to achieving excess profits:

• Understanding the value of options: what you own is a right with positive Delta and positive Gamma.
• Hedge options instead of holding tokens: Use option pricing models to calculate Delta and hedge in the perpetual contract market.
• Gamma Scalping: Continuously profiting from market fluctuations by dynamically adjusting hedge positions.

Operations near the strike price:

• When the price approaches and exceeds the strike price, the option Delta quickly approaches 1.
• Correspondingly increase the hedging short position.
• At the expiration of the option, if the price is above the strike price, exercise the option and immediately sell it in the market.

Conclusion and Operational Suggestions

1. Initial token handling: Immediately sell 2.3 million tokens, use 700,000 to acquire operational USDT, and 1.6 million to hedge the remaining position.

2. When the price is below $1.25: Do not actively buy or sell non-hedging tokens, continue performing CEX market making, DEX LP hedging, and options Gamma Scalping.

3. When the price is above the exercise price: Execute a risk-free delivery process, buy tokens from the project party at a low price, immediately sell them at a high price in the market, and simultaneously close the hedged position.

This strategy breaks down complex market-making protocols into a series of quantifiable, hedgable, and profitable market-neutral operations. The success of market makers does not rely on market predictions, but rather on outstanding risk management capabilities and technical execution.

Under market mechanisms, the behavior of market makers is a rational choice made through precise calculations, rather than malicious actions. As participants, we should always maintain a sense of awe towards market Algorithms and deeply understand their operational mechanisms.