Do you also frequently stumble across someone saying or writing: „option market makers need to delta hedge their gamma exposure“ or something similar? But what does that even mean? And is there any useful information to be gleaned or is it simply gobbledygook investment professionals sprout to make themselves seem smarter than they really are?
I think, the best trading edges arise when market participants are forced to act in a certain way – and that seems to be exactly what is playing out here beneath the surface of the market. The strongest effect is visible in the S&P 500, because it is such a widely traded index.
The mechanism behind gamma exposure
Market makers buy and sell options from and to regular people and must hedge their market risk by buying or selling the underlying equities or futures, if they want to avoid going broke sooner or later. This process is kind of tricky because options move differently in comparison to the underlying market depending on how far away from their strike price they are (the delta) and this sensitivity changes constantly. When dealers are highly exposed to this change (the gamma), they need to buy or sell futures with every point the market moves to adjust their hedge (delta hedging) in order to stay neutral to its direction.
Now this dealer gamma exposure can be long or short with opposite effects (which causes a lot of the confusion and cryptic charts as the example below from spotgamma.com) and can amount to billions of dollars of forced supply and demand for each point the S&P 500 moves.
If they are long gamma, then for each point the S&P 500 moves up, dealers have to sell equities or futures by the net gamma amount (see chart), when it moves down they buy. Volatility is suppressed by this constant force of supply and demand counter to the market´s direction – this is what we often witness in the form of slowly rising markets or long sideways moves oscillating in a tight range around one price point. Price seems to be „pinned” to a certain level.
Here the reverse effect takes place: for each point the S&P 500 moves down, dealers have to sell equities or futures and vice versa, thereby exacerbating the market´s move. Volatility spikes and suddenly stocks are going crazy.
Switch from long gamma to short gamma
At a certain point in a falling market long gamma switches to short gamma (the „volatility trigger“ in the chart) – a key area around which market behavior can change dramatically.
On expiration days delta and gamma exposures often change significantly depending on how expiring options contracts are rolled forward, which can cause sudden jumps in market price as dealers hedge these changes.
- At the switching point from long to short gamma we often see a strong reversal to the upside (e.g. during the overnight drop on January 8th during the recent Iran mini-crisis), when the volatility trigger acts as a support area. But when price breaks through to the downside, we can expect much larger daily moves in either direction than we saw before. This often coincides with a volatility spike and often an inversion of the VIX futures term structure (a warning signal for elevated risk in the market).
- There has been a tendency for markets to rise in the week in front of the quarterly option expiry date. (Kevin Muir explains the reason for this in detail in this MacroTourist Blog post)
- Spotgamma.com also models potential ceilings and floors to market moves at the highest concentration of strike prices for call or put options.
Access to such in-depth research used to be the domain of large institutions, but today anyone can get easy access to sophisticated information that is modeled out from options data by, for example, Nomura or spotgamma.com.
Overall this seems to be pretty useful to me!