Market Making Algorithm Unveiled: "Market Support" or "Market Dumping"? How Do Market Makers Use Tokens Borrowed from Projects?

Original Author | danny (@agintender)

Compiler | WuBlockchain Aki Chen

Original Source Link:

https://x.com/agintender/status/1946429507046645988

Disclaimer: This article is a reposted piece. Readers may refer to the original source for more information. If the original author has any objections to the form of reposting, please contact us and we will make modifications as requested. The repost is intended solely for information sharing and does not constitute any investment advice, nor does it represent the views or positions of WuBlockchain.

“If the tokens were borrowed based on strength, why should they help you wholeheartedly?” What really happens after a project hands over tokens to market makers? This article unveils the core logic of algorithmic market making, explaining how market makers use your tokens to generate trading depth, price stability, and market confidence.

Conclusion:

Due to the current lack of liquidity in altcoins, the optimal strategy for market makers under the call option model is to sell the tokens immediately after obtaining them from the project team.

You may ask, if the tokens are sold immediately, and they increase in price later, doesn’t the market maker need a lot of money to buy them back?

Reasons:

1. The market maker’s strategy is delta neutral, meaning they do not hold positions — they aim for a risk-free profit.

2. The call option actually sets a maximum price, limiting the market maker’s exposure to risk (even if the price increases 100-fold, they can still buy it back at 2x the price).

3. These types of market maker contracts usually last 12–24 months, and with the current number of projects on the market, most of them peak right after launch. How many will last for a year?

4. Even if the project lasts 1–2 years and the token price skyrockets, the profits gained from the price fluctuation would be sufficient to cover the loss from the early “sell-off.”

Introduction

Recently, the market has been doing well, and several of my friends’ projects are planning to conduct their Token Generation Event (TGE) soon. Right now, they’re stuck on choosing the right “market maker.” They keep coming to me with the terms from the market makers, asking what I think about them. What’s the deal with these conditions? Are there any pitfalls? What will market makers do with our tokens once they have them? Will they really provide liquidity? Especially after reading the report on Movement.

1. Market Background

Generally speaking, there are three common collaboration models for market makers:

● Renting a market-making bot: The project provides funds (tokens + stablecoins), while the market maker provides “technical” and “personnel” support. The market maker charges a retainer fee and/or a profit-sharing fee (if applicable).

● Active market maker: The project provides tokens (sometimes a small amount of stablecoins), and the market maker provides funds (sometimes no stablecoins), conducts market making and community guidance. The main goal is to sell tokens, and after the sale, the project and market maker split the profits according to an agreed ratio.

● Call option (common): The project provides tokens, and the market maker provides funds (stablecoins), but the market maker holds a call option. If the price exceeds the agreed price, the market maker can exercise the option to buy at a lower price.

This article will focus on explaining the most common model, the call option model.

2.Market-Making Terms for the Call Option Model

From the perspective of a delta-neutral market maker, the project cooperation terms typically look like the following (usually for 12–24 months):

Note: This is purely fictional. If it looks familiar, it’s just a coincidence.

(1) CeFi Market-Making Obligations

The market maker is required to provide liquidity for token ABC on the following exchanges:

Binance: Place buy and sell orders worth $100000 each within a ±2% price range (i.e., you are responsible for $100k USDT + $100k equivalent of ABC). The spread should be controlled within 0.1%.

Bybit and Bitget: Similarly, provide buy and sell orders worth $50000 each within a ±2% range (you need to invest $50k USDT + $50k equivalent of ABC), with the spread also controlled within 0.1%.

(2) DeFi Market-Making Obligations

You are required to provide a liquidity pool of $1000000 for ABC on PancakeSwap, with 50% in USDT and 50% in ABC token (i.e., $500k USDT + $500k ABC).

(3) Project Provides Resources

The project will lend you 3 million ABC tokens (2% of the total token supply, currently valued at $3M, meaning the FDV is $150M).The current market price of ABC is $1/token.

(4) The Project Offers You an Option Incentive (European-style Call Options)

If the market price of ABC token increases in the future, you can choose to exercise the option to purchase tokens. The specific terms are as follows:

If the market price does not reach the corresponding strike price, you can choose not to exercise the option and will not incur any obligations.

Based on the above conditions, as a market maker strictly following a delta-neutral strategy, how would you conduct the overall market-making and hedging arrangements after receiving the 3 million ABC tokens to ensure you don’t incur losses due to token price fluctuations?

3.Reflection: If you were the market maker, what would you do?

3.1. Core Goals and Principles

(1) Always maintain a Delta-neutral position (this is the key premise): The net position (spot + perpetual contracts + liquidity pool + option Delta) must always be close to zero to fully hedge against market price fluctuations.

(2) Do not take directional risk: Profits should not depend on the rise or fall of the ABC token price.

(3) Maximize non-directional profits: The profit sources come from four core channels:

a. The buy and sell spread (Spread) on centralized exchanges (CEX).

b. Trading fees from liquidity pools (LP) on decentralized exchanges (DEX).

c. Volatility arbitrage (Gamma Scalping) through hedging over-the-counter (OTC) options.

d. Potential favorable funding rates (Funding Rates).

3.2. Initial Setup and the Critical First Step: Hedging

This is the most crucial step in the entire strategy. The action is not determined by price predictions, but by the assets received and the obligations assumed.

3.2.1 Asset and Obligation Overview

Assets Received (also liabilities): 3000000 ABC tokens. This is a loan, and we are obligated to repay 3000000 ABC tokens in the future.

Obligation Deployment (Inventory and Capital):

● Binance Market Making: 100000 ABC (Sell Order) + 100000 USDT (Buy Order)

● Bybit/Bitget Market Making: 100000 ABC (Sell Order) + 100000 USDT (Buy Order)

● PancakeSwap LP: 500000 ABC + 500000 USDT

Total Market Making Inventory: 700000 ABC

Total USDT Needed for Market Making: 700000 USDT

3.2.2 Initial Net Exposure Calculation (Simple Version)

Note: The specific numbers are not important; what matters is the logic.

If we only consider the token loan itself, holding 3 million ABC tokens indeed perfectly hedges the obligation to repay 3 million ABC tokens. However, as a market maker, we cannot focus solely on the loan; we must look at the net position of the entire operation.

USDT Funding Gap:

The market-making obligations require at least 700000 USDT to be deployed immediately for buy order liquidity. Where does this money come from? The most direct, most in line with the spirit of the agreement, and consistent with the current market trend where new tokens peak right after launch, is to sell some of the borrowed ABC tokens to obtain it.

ABC Tokens to Be Sold to Obtain USDT:

To acquire 700000 USDT, at the current price of $1, we must sell at least 700000 ABC tokens. (Typically, this would happen during the “initial liquidity window” or OTC, and a conscientious market maker may even open a long position for hedging.)

Recalculation of Net Exposure:

Initially, we have 3 million ABC tokens.

700000 ABC is used for CEX and DEX sell order inventory.

Another 700000 ABC is sold to obtain USDT for buy order liquidity.

At this point, the remaining ABC tokens are:

3000000–700000 (inventory) — 700000 (sold for USDT) = 1600000 ABC.

Now, these 1.6 million ABC tokens represent the true net long position (Net Long Delta). We no longer have a USDT funding gap, but the 1.6 million tokens we hold are unhedged. If the price drops, we will face losses.

3.2.3 Initial Hedging Operation: Answer to “When to Sell?”

The answer is: Sell immediately. The amount to be sold is precisely calculated to achieve two goals:

(1) To obtain the USDT needed for operations.

(2) To hedge the remaining token exposure.

Action:

At the moment the market-making operation starts, our automated trading system will immediately sell a total of 2300000 ABC tokens in the market.

700000 ABC will be sold to obtain the 700000 USDT needed for market making.

The remaining 1600000 ABC will be sold to hedge the unhedged token position.

Why this way?

● Meet operational needs: This action provides the necessary USDT liquidity to fulfill all market-making obligations.

● Achieve true Delta neutrality: After selling the entire 2.3 million ABC tokens, we will have no unhedged ABC token exposure. Our risk is fully neutralized.

● Lock in risk: We fully transfer the price fluctuation risk, focusing solely on profiting from market making and volatility.

We will not hold any “naked” ABC tokens waiting for the price to rise. Every token position, whether long or short, must be precisely hedged.

3.3. Dynamic Hedging: 24/7 Risk Management

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

CEX Market Making Hedging:

When our buy orders are filled, we will purchase ABC (creating a long Delta position), and the system will immediately short an equivalent amount of ABC in the perpetual contract market. The reverse happens when sell orders are filled. Through this method, we earn a 0.1% spread while maintaining Delta neutrality.

DEX LP Hedging:

The 500000 ABC inventory in PancakeSwap carries the risk of impermanent loss, which is essentially a short Gamma position. Our model continuously calculates the LP’s Delta (negative when prices rise, positive when prices fall), and uses perpetual contracts for the reverse hedge.

3.4. Option Strategy: The True Profit Engine

This is the most sophisticated part of the entire trade, and it is the key to surpassing simple market making and achieving excess profits.

3.4.1 Understanding the Value of Options

What we hold is not the token, but a right. This right (a three-tier call option) has a positive Delta and positive Gamma. This means:

● Positive Delta: As the price rises, the value of the option increases.

● Positive Gamma: The more volatile the price, the faster the change in Delta, which works to our advantage.

3.4.2 Hedge the Options, Rather Than Hold the Tokens

We won’t simply wait for the price to reach $1.25, $1.50, or $2.00. We will hedge the Delta of the options.

Initial Hedging:

Using an option pricing model (such as Black-Scholes), we calculate the total Delta of these three options at the current price of $1.00. Assume the result is +400000. To remain neutral, we must short an additional 400000 ABC in the perpetual contract market. (The larger the option, the more we need to short.)

Gamma Scalping:

This is the dynamic answer to “when to buy or sell.”

Scenario 1: Price rises from $1.00 to $1.10

The Delta of the option increases (as it gets closer to the strike price), for example, from +400000 to +550000.

Our net position is no longer zero, but we now have a +150000 long position.

Action: Our system will automatically sell 150000 ABC in perpetual contracts to restore neutrality.

Scenario 2: Price drops from $1.10 to $1.05

The Delta of the option decreases, for example, from +550000 to +500000.

Our existing short hedge position is now “too large,” resulting in a -50000 net short position.

Action: Our system will automatically buy 50000 ABC in perpetual contracts to cover the position and restore neutrality.

Isn’t it amazing?! Through hedging, we naturally achieve “selling high, buying low.” This process repeats itself, and we “skim” profits from every market fluctuation. This is Gamma Scalping. We earn money from volatility, not from direction.

3.4.3 Operations Near the Strike Price

When the price approaches and exceeds $1.25:

● Our first-tier option becomes in-the-money. Its Delta will quickly approach 1 (1000000).

● Our short hedge position will accordingly increase to nearly 1000000 ABC.

Exercise Decision:

At the time of option expiration, if the price is above $1.25, we will exercise the option.

Action:

● Pay $1250000 USDT to the project, and acquire 1000000 ABC tokens.

● Immediately sell the 1000000 ABC tokens in the spot market.

● Simultaneously close out the 1000000 ABC short position in the perpetual contract market, which was established to hedge the option.

Profit:

The profit comes from the difference between the strike price and the market price, as well as the gains accumulated from Gamma Scalping throughout the process.

The logic is exactly the same for strike prices of $1.50 and $2.00.

We are not betting on whether the price will reach the strike price, but instead, we are continuously profiting by dynamically adjusting our hedge positions during price fluctuations, and executing risk-free exercise arbitrage when the price does indeed reach the strike price.

3.5. Conclusion and Operational Recommendations

Initial Token Handling:

Sell 2.3 million ABC tokens immediately. Of this, 700,000 ABC will be used to obtain the USDT needed for operations, and 1.6 million ABC will be used to hedge the remaining positions. Never hold any unhedged token positions.

Price < $1.25:

Do not actively buy or sell any non-hedged ABC tokens. Continue CEX market making, DEX LP hedging, and option Gamma Scalping. Profits will come from spreads, fees, and volatility.

Price > $1.25 (and subsequent strike prices):

When the price is significantly above the strike price, our hedging engine will have already established the corresponding short positions. The exercise becomes a risk-free settlement process: buy tokens from the project at a low price and immediately sell them at the market price, while simultaneously closing out the hedged position.

This strategy breaks down a seemingly complex market-making agreement into a series of quantifiable, hedged, and profitable risk-neutral operations. A market maker’s success does not depend on market predictions, but on excellent risk management and technical execution.

After reading this, you should understand that it’s not the market maker having an issue with you or “deliberately” dumping the price. Instead, under this mechanism and algorithm, the initial “selling” of tokens and establishing short positions is the locally optimal solution for the market-making strategy.

It’s not that they are bad, but a rational choice after weighing the pros and cons.

The market is ruthless. The deals that seem the best and the least risky are often the result of meticulous calculations.

When you cannot see the risks, you become the risk.

May we always maintain a respectful understanding of market algorithms.

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