Small Trader Alpha #5 - Market Making in Binary Markets

How to use existing option markets to price binary options for easy market making.

Introduction

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Small trader alpha is a series of articles I write about real trades that are actually profitable at present. They exist because they are only available to small traders due to limited capacity. This doesn’t mean they should be shunned. It’s often the case that those who care to exploit it don’t know how and those who know how don’t care because they seek larger opportunities. Hence we bridge this gap in the small trader alpha series. With that said, on with the article:

A very interesting trade exists at the moment regarding market making event prediction markets for financial assets.

It’s not often where we get given a really great fair value model for free, but this is one of those examples.

Sites like Kalshi offer the ability to bet on yes/no outcome questions. This effectively ends up creating binary option markets when they start asking questions like:

“Will the S&P500 end the year over 4000?”

The flow on these bets are almost exclusively retail, but more importantly we can actually use option prices for the real tradfi markets on these assets to figure out the implied probability of outcomes.

In this article, we break down this opportunity and all of the components that would go into taking advantage of it from start to finish.

We include code and practical details of how to implement this. To my understanding there is a fairly decent amount of flow (if you’re a small trader or team, maybe not for bigger shops), lack of competition, and attractive incentives from exchanges.

There’s also a very good arbitrage in addition to all this that I’ll dive into.