How Can a Market Maker Use a “Volatility Surface” to Manage Gamma Risk?
A market maker uses a volatility surface to price and manage the Gamma risk of their entire option book. The surface is a 3D plot of implied volatility across different strikes and maturities.
By observing the surface, the market maker can identify areas where Gamma is highest (steepest part of the surface) and adjust their hedging strategy, often by trading other options or using more sophisticated hedging instruments to neutralize the overall portfolio Gamma.
Glossar
Hedging Instruments
Mitigation ⎊ Hedging instruments, within cryptocurrency and derivatives markets, function as strategic offsets to potential adverse price movements, extending beyond simple directional protection.
Implied Volatility
Expectation ⎊ This value represents the market's consensus forecast of future asset price fluctuation, derived by reversing option pricing models using current market premiums.
Market Maker
Genesis ⎊ The concept of a market maker within cryptocurrency derivatives, options trading, and broader financial derivatives fundamentally addresses liquidity provision and price discovery.
Volatility Surface
Calibration ⎊ The volatility surface, within cryptocurrency options, represents a three-dimensional depiction of implied volatility indexed by strike price and expiration date; its calibration involves determining the parameters of a stochastic volatility model to best fit observed market prices of options contracts, a process crucial for accurate derivative pricing and risk assessment.
Realized Volatility
Measurement ⎊ Realized volatility, within cryptocurrency and derivatives markets, represents the historical fluctuation of asset prices over a defined period, calculated using observed transaction data.
Gamma Risk
Exposure ⎊ Gamma risk, within cryptocurrency derivatives, represents the sensitivity of an option's delta to changes in the underlying asset's price.