Option Expiration, Gamma Exposure and all the rest

This is a follow-up post all about practical trading ideas around gamma exposure and OPEX. For the basics you should quickly read this article first – I explain the concept and come to the conclusion, that we are seeing a market mechanism at work that can be very useful to active traders.

The best trading edges arise when market participants are forced to act in a certain way – and that is exactly what is playing out beneath the surface of the market in the case of gamma exposure.

Gamma exposure in a market crash

The first couple of months of 2020 are a prime example of how the mechanics of gamma exposure can influence market action in a very powerful way.

Gamma ???
Gamma is the rate of change in an option’s delta – meaning how fast the sensitivity of an option´s price to the move of the underlying security changes, while its price moves closer to or farther away from the option´s strike price.

The basic concept is that, depending on the market environment, option market makers are exposed to gamma differently, and will need to constantly adjust their hedging activity to control their risk – this creates very real buying or selling pressure in the market.
In a quiet up-move dealers’ gamma exposure is usually long and when the S&P 500 moves up dealers will sell index futures in an amount that can reach billions of dollars for each single point the index moves. They do the opposite when the index falls and thereby suppress volatility.

Long gamma exposure suppresses volatility.

We could see this play out clearly when the S&P 500 climbed to new all-time highs from October 2019 to February 2020 – gamma exposure was extremely long and price seemed to be „pinned” to certain levels.
Even the bigger market drops at major upheavals e.g. the beginning of an Iran crisis or the first appearance of the Coronavirus were immediately reversed.

gamma exposure was extremely long and price seemed to be „pinned” to certain levels

But by the end of February the opposite happened. Gamma exposure switched to short gamma after the market fell right through the zero gamma level. Option dealers suddenly had to hedge their risk by selling more and more S&P futures with every point the index dropped (and vice versa) – volatility exploded and daily market moves in both directions became bigger and bigger.

Gamma exposure switched to short gamma

It is no coincidence, that this violent market crash began the day after monthly option expiration in February and found its bottom just after the March OPEX. On both dates a large percentage of the gamma exposure influence vanished as options expired – first volatility suppressing long gamma exposure was reduced opening the gates for the market drop, then short gamma was reduced and wild market gyrations could be brought under control.

Gamma exposure effect on next day´s return

This chart visualizes the direct causality between gamma exposure and subsequent price moves:

In general the gamma exposure effect boils down to this: short gamma exposure supports large price moves while long gamma exposure calms down volatility – this effect is pronounced and reliable, because it is based on forced market maker behavior.

It´s easy to see that an awareness of this hidden market force can be a decisive advantage for traders trying to anticipate major turning points or the potential regime change from a low volatility to a high volatility environment to adjust their trading and market exposure. 

An essential tool to achieve this is to look for what might occur around the monthly option expiration dates. (You can usually get a glimpse at the current gamma exposure and projected gamma roll-off through spotgamma.com or Nomura via zerohedge.com some days before Opex dates).

A closer look at monthly option expiration dates (OPEX)

monthly option expiration dates

OPEX often marks decisive points in the market, as it ceases to be „pinned“ to a level (long gamma in an uptrend) or stops being relentlessly driven into one direction (a short gamma driven move), when dealer gamma exposure is reduced by expiring option contracts. 

This became quite obvious in December 2019 and March 2020, when prices suddenly reversed direction after a final sell-off the day after OPEX. In a relentless sell-off short gamma exposure and its effect on market moves keeps rising until it is suddenly taken off the table when heavily traded near-term options expire.

The actual prices of open options were also influenced significantly – they became a lot cheaper as market makers could afford to price options lower after a lot of tail risk had rolled off their books. The frantic crash hedging activity had caused options to become widely overpriced.

Owners of longer-term options going into March 20th were left holding the bag and had to take big losses even at points where volatility and the price of the underlying did not differ. Awareness of the situation could have helped to avoid losses at the very least.

In quiet bull markets a potential change in direction is not the most relevant point, but rather the tendency that price becomes „unstuck“ from the level it traded around going into the option expiration. The index then might turn in its direction or – in a longer trending move – continue on its next move in the direction of the trend.

A large directional move after OPEX is likely to happen.

Read more about my main investing model „The Meta Strategy“ in my free, new eBook – it combines a nuanced weighting of fundamental and technical indicators with the VIX futures term structure as one key component.

Trading Ideas and Strategies

Gamma awareness is an important piece of the puzzle in my market analysis, but it is also possible to formulate more specific trading strategies around the effect. They can be quite effective, because they rely on market patterns that are not easily changed by market participants adjusting their trading behavior – option market makers must keep their books balanced through hedging. 

We can trade such patterns with greater confidence.

Buy the Gamma Dip

This is one of the few short term patterns I trade, because the success rate is quite high. I created and traded the strategy before I heard about the strong mean-reversion tendencies in a market setup where market makers are heavily long gamma.
I now realize that there is actually a dependable market mechanism that forms the basis for this S&P 500 strategy: in a quiet bull market, when option dealers are long gamma, a falling index forces dealers to buy futures and drive the price back up – causing a reliable, repeated pattern.

The strategy itself is very simple: it buys the first significant dip in an S&P up-move when long gamma exposure is high and then sells at the previous high. Here is how it backtests (including Kelly optimal bet sizes for each trade):

Buy the Gamma Dip strategy statistics
Buy the Gamma Dip strategy statistics using a pullback of 1-2 times the average daily move of the S&P 500.

It should be fairly easy to create your own workable strategy from the basic concept.

I reserve my exact rules and parameters (set up, instruments, position size, entry, stop loss and exit points) for my basic and premium subscribers. My weekly premium member newsletter contains the strategy, as a small part of a holistic investing and trading portfolio approach, and provides the latest set-up as I trade it.

A key level to watch: the point where gamma exposure flips from long to short

The zero gamma flip or volatility trigger can be used as one would a traditional support zone.

An important part of successful trading is staying in the game when market behavior changes and strategies suddenly cease to work. The VIX futures term structure is my most reliable indicator to judge when to do this – it tells me when the market regime becomes unsuitable for risky assets and strategies (e.g. short volatility strategies).

When the index drops to zero gamma, the switching point from long to short gamma, we often see a strong reversal to the upside as the level acts as a support area. But, if price breaks through to the downside, we can expect much larger daily moves in either direction than we saw before. Danger in the market increases and exposure to risk should be reduced decisively. 

This usually coincides with a volatility spike and often causes an inversion of the VIX futures term structure.

Selling options short before OPEX in an extreme price cascade

The observations around December 2019 and March 2020 expiration dates lead to another idea, namely to profit from the expected collapse in option prices when gamma exposure risk rolls off dealer´s books.

A short strangle (selling an out-of-the money put and a call simultaneously) opened the day before OPEX will net high option premia when volatility is very high and provide a margin of safety agains market moves in any direction. It quickly profits when both put and call option prices collapse within a couple of days.

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