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In a double-auction market, buyers and sellers are always balanced in number -- a traditional market-maker in such markets doesn't really hold any assets/take any position long-term.

However, with a logarithmic market maker, the market maker holds the opposite side of every trade, and the price actually depends on the imbalance in the number of "YES" and "NO" stocks issued (if they are equal, all prices will just be $0.5).

In particular in an option market, the market maker may trade with option-buyers and option-writers, and you can end up with more options written than bought.

How, then, does a market-maker know when to exercise the options it holds (i.e. make the option-writers "pay up")?

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  • It's like any other contract. If the contract allows you to do something, you have the right to do it. So if you have the right to exercise you can do so if you think it's beneficial.
    – AKdemy
    Jun 29, 2023 at 15:52
  • Some details about early exercise (only possible with American options), particularly when it is optimal to exercise can be found here.
    – AKdemy
    Jun 29, 2023 at 16:30
  • So the market maker needs to intelligently/strategically decide when to exercise? I was hoping for a mechanism by which it doesn't need to take any risk/position of its own aka letting the market decide when to exercise. Jun 29, 2023 at 17:12
  • The market maker will obviously exercise a position if it is beneficial. Other than that, all positions in the book will be hedged (that's what the Greeks are used for). However, I don't think questions about market making really suit personal finance. After all, market makers are qualified professionals.
    – AKdemy
    Jun 29, 2023 at 17:14

1 Answer 1

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An option is like any other contract. If the contract allows you to do something, you have the right to do it. So if you have the right to exercise you can do so if you think it's beneficial.

Some details about early exercise (only possible with American options), particularly when it is optimal to exercise can be found here.

The market maker will obviously exercise a position if it is beneficial (otherwise they would throw away money) and it is quite mechanical because you have simple formulas for optimal conditions. You cannot "let the market decide when to exercise" if you as a market maker have the right. In this case, the counterparty has no right and just an obligation. If the market maker actually wrote an option (sold them), they have no right to exercise anyways. It's only for bougth options.

Other than that, (almost) all positions in the book will naturally be hedged (that's what the Greeks are used for).

Ultimately, I don't think questions about market making really suit a site about personal finance. After all, market makers are qualified professionals.

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  • nitpick but Bermudan options, for example, can also be exercised early
    – MD-Tech
    Jun 30, 2023 at 7:03
  • True, but leaving swaption markets aside, Bermudan options basically aren't liquid at all (in equity, FX, commodities). Also, the exercise logic is the same (exercise iff beneficial). In general, early exercise is not often beneficial.
    – AKdemy
    Jun 30, 2023 at 9:41
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    I did say it was a nitpick!
    – MD-Tech
    Jun 30, 2023 at 9:48

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