How Market Makers Price Crypto Options

Market makers play an important role in crypto options markets by continuously providing bid and ask prices. Their objective is to offer liquidity while managing the risks created when traders buy or sell options against them.

Pricing a crypto option is more complex than predicting whether Bitcoin or Ethereum will rise or fall. Market makers combine mathematical models, implied volatility, market data, inventory exposure and hedging costs to calculate a fair value. They then adjust that value to produce tradable bid and ask quotes.

What does an options market maker do?

A market maker provides two prices:

• Bid: The price at which the market maker is willing to buy an option.
• Ask: The price at which the market maker is willing to sell an option.

The difference between them is the bid-ask spread.

Market makers may quote hundreds of options across different assets, strike prices and expirations. When a trader executes against a quote, the market maker inherits the opposite position and must manage the resulting exposure.

Step 1: Determining the underlying reference price

The first input is the price of the underlying cryptocurrency. However, market makers do not always use the current spot price directly.

Options expiring in the future are frequently priced using a corresponding forward price. This reflects the expected relationship between spot, futures, funding, interest rates and the time remaining until expiration.

For example, if BTC spot is trading at $70,000 but the one-month futures price is $70,500, the market maker may use a forward price close to $70,500 when pricing an option expiring in one month.

The quality of the underlying price index is also important. An unreliable or easily manipulated reference price increases the market maker’s risk.

Step 2: Building an implied volatility surface

Implied volatility, or IV, is one of the most important option-pricing inputs. It represents the level of future volatility reflected in current option prices.

Market makers do not normally use one IV level for every contract. They build a volatility surface that assigns different volatility levels to different strikes and expirations.

The surface includes:

• At-the-money volatility: IV for options with strikes close to the underlying price.
• Volatility skew: The difference between IV for puts and calls at different strikes.
• Volatility smile: The shape created when out-of-the-money options trade at different IV levels from at-the-money options.
• Term structure: The difference between short-term and long-term implied volatility.

Demand also affects the surface. If traders aggressively buy downside protection, put IV can rise relative to call IV. Before a major economic announcement, short-dated options may become more expensive because the market expects a larger move.

Step 3: Calculating theoretical value

Market makers feed the relevant inputs into a pricing model. Black-Scholes, Black-76 and modified versions of these models are commonly used as starting points.

Typical inputs include:

• Forward or underlying price
• Strike price
• Time until expiration
• Implied volatility
• Interest rates and funding assumptions
• Option type
• Settlement and contract structure

The model produces a theoretical option value and a set of risk sensitivities known as the Greeks.

A model does not provide a guaranteed correct price. It estimates fair value based on assumptions about future volatility and market behaviour. Market makers often use proprietary models to account for the specific characteristics of crypto markets.

Step 4: Measuring the Greeks

Market makers manage an entire portfolio rather than evaluating every option in isolation. The Greeks help them understand how that portfolio may change.

• Delta measures sensitivity to movements in the underlying cryptocurrency.
• Gamma measures how quickly delta changes when the underlying price moves.
• Vega measures sensitivity to changes in implied volatility.
• Theta measures the effect of time passing.
• Rho measures sensitivity to interest rates.

Suppose a trader buys BTC calls from a market maker. The market maker becomes short calls and may gain negative delta exposure. To reduce this risk, the market maker can buy BTC futures or perpetual contracts.

This creates a delta hedge, but the position is not risk-free. As BTC moves, the option’s delta changes, requiring the hedge to be rebalanced. Sharp price moves can make this process expensive, especially when gamma exposure is high.

Step 5: Adjusting for inventory and hedging costs

The theoretical value is only the starting point. Market makers adjust their quotes for real trading conditions.

Important adjustments include:

• Current delta, gamma and vega inventory
• Liquidity in spot, futures and perpetual markets
• Expected hedging and rebalancing costs
• Order size
• Market volatility
• Risk of rapid or informed order flow
• Exchange fees, funding and margin requirements
• Available capital
• Competition from other liquidity providers

If a market maker already has a large short-vega position, selling additional options would increase the same risk. The market maker may respond by raising the ask price or quoting a higher implied volatility.

At the same time, it may offer a more competitive bid to encourage trades that reduce its existing exposure.

Why do bid and ask prices differ?

The bid-ask spread compensates the market maker for providing liquidity and taking risk.

Spreads generally become wider when:

• Markets are highly volatile
• The underlying asset is difficult to hedge
• The order is large
• An option has limited liquidity
• Expiration is very close
• Major market events are approaching
• Price data or trading systems are experiencing delays

Liquid BTC and ETH options may have tighter spreads than options on smaller assets because their underlying markets are usually easier to hedge.

Simple pricing example

Assume BTC’s one-month forward price is $70,000 and a market maker is pricing a one-month call with a $70,000 strike.

Based on the volatility surface, the market maker estimates an IV of 50% and calculates a theoretical premium. Instead of quoting exactly at that value, it may create a market around it:

• Bid based on 49% IV
• Ask based on 51% IV

If another trader requests a large quantity, the market maker may widen the quote to account for the additional inventory and hedging risk.

If the trade helps offset an existing position, it may offer a more competitive price.

How are RFQ option prices calculated?

For an RFQ, market makers receive the exact transaction details, including the size, direction and any option legs.

They calculate the theoretical value and then evaluate how the complete transaction would affect their portfolio. A multi-leg strategy may receive more efficient pricing if the risks of its individual legs partially offset each other.

For example, a call spread contains both a long and a short call. Pricing it as one package can reduce leg risk and allow the market maker to assess the net delta, gamma and vega exposure.

Through Coincall RFQ, eligible option transactions can be sent to liquidity providers for dedicated pricing, allowing traders to compare available quotes before deciding whether to execute.

Final thoughts

Crypto options market makers do not simply choose a premium based on their view of the market. They begin with the underlying forward price and volatility surface, calculate theoretical value and Greeks, and then adjust their quotes for inventory, liquidity, hedging costs and market conditions.

Understanding this process can help traders interpret option prices, implied volatility and bid-ask spreads more effectively. However, even sophisticated models cannot eliminate market risk, especially during periods of extreme volatility.

This article is for educational purposes only and does not constitute financial advice.