Options: Market Making on Options

Question 1

What is a market maker?

Answer 1

A market maker is a firm/individual that actively trades a security (or a derivative) on both sides quotin systematically a bid and an ask price

Question 2

What is an example of a market maker’s risk limits?

Answer 2

Easiest possible structure: Delta limit + Vega limit
The limit is a sort of guidance on what prices to set (Delta too high -> set a price so more contracts are bought by others and Delta gets reduced)

Question 3

What does quoting for market makers in terms of implied volatilities mean?

Answer 3

The volatility skew means the market maker can set price based on implied volatility.
To incentivize the counterparty to buy calls lower ask volatility
To incentivize the counterparty the counterparty to buy puts lower ask volatility

And vice versa