What are the most persistent edges in the market? When market participants are forced to buy or sell in a predictable fashion we get reliable behavior that can be exploited and that is unlikely to disappear.
One such hidden market force has become increasingly stronger in recent years: option market makers gamma exposure.
With large trading positions in speculative options the market neutral option dealers must buy and sell underlying securities to hedge their risk. And exactly this speculative option positioning is growing like crazy while volumes in the stock market are falling.
Hedging activity represents an increasing part of the demand and supply that changes price levels in the market.
How does Gamma Exposure work?
When the price of a security changes option market makers are forced to adjust their hedges by buying or selling the security underlying an option (e.g. a stock or an index future). This is because the price relationship between option and underlying (delta) constantly changes (gamma) and dealers must hedge these changes to avoid taking on directional market risks.
Dealer gamma exposure can be long or short (depending on options positioning in the market) with opposite effects amounting to billions of dollars of forced supply and demand:
Long Gamma: dealers hedge by buying more with each point a security falls (and vice versa) and suppress volatility.
Short Gamma: dealers hedge by selling more with each point a security falls (and vice versa) and increase volatility – often leading to large directional moves.
You can find more background details here and trading ideas here.
Gamma Exposure Effects are Getting Stronger
Recent data shows how the activities of option speculators and therefore dealer’s hedging requirements are becoming an increasingly significant part of the overall market.
This increases the edge contained in options knowledge: how are investors, traders and dealers positioned?
Options volumes are now bigger than stock volumes
S&P 500 goes up and volumes go down
As stock liquidity is falling options activity magnifies or suppresses underlying moves purely as an effect of dealers hedging – their trades are becoming a significant part of the overall volume.
Bullish options speculation has steadily risen in recent years…
…with traders increasingly buying more calls than puts.
How can we use information on current option activity and what are tradable effects?
Option expiration dates (OPEX) are interesting because gamma exposure that has built up over time often changes significantly overnight – a previous article goes into additional detail. The recent August 21st OPEX, for example, was a predictable „unclenching” event that led to a tradable breakout.
Read about my main investing model „The Meta Strategy“ in my free, new eBook – it combines a nuanced weighting of fundamental and technical indicators to systematically adjust asset allocation and trading strategies to market regimes.
Call Roll Gamma Trap
In the beginning of August the precious metal mania generated extreme options volumes: Silver ETF, SLV, traded more calls than SPY calls; Gold (GLD) calls were number 3 and Gold Miners (GDX) number 5 among all US ETF calls (SLV options volumes approx +215% vs 20d avg, GLD +110% and GDX +140%).
A rise in in these ETF can be caused by calls being rolled up and precious metals got caught in a “Call Roll Gamma Trap” – a self-reinforcing positive feedback loop. Dealers taking the other side of traders have a negative gamma position which infers they need to buy ETFs as they rise and sell as they drop – this cycle first places a constant bid to the market and finally rolls over to cause a violent correction when large amounts of in-the-money calls are sold.
Often dealers make larger adjustments and ETF providers adjust their precious metal holdings in the overnight session leading to large gaps as the ETF price rips higher.
In a market crash as in March 2020 the opposite effect can increase volatility to the downside.
These are some recent examples of observable effects of gamma exposure – read my previous article “Option Expiration, Gamma Exposure and all the rest“ for additional detail, ideas and background.
Dig deep into option mechanics with a recent paper by Squeezemetrics.
Good luck in your trading & thank you for reading!
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Great article! can you please explain more about who is gamma long or short. If traders are long gamma (long calls) that’s mean dealer is short gamma (short call) right? and the same for put, if traders are net long gamma (more long puts than short puts) then dealer is short gamma (short put) because opposite to traders?
Thanks Anthony! The post talks about dealer positioning. Good sources (e.g. spotgamma.com or squeezemetrics.com) use complex models that take current call & put positions (Dealers usually are net short puts, long calls) into account to calculate a net dealer gamma exposure. This means, if GEX shows long gamma exposure of $1bil then dealers will have to sell $1bil in S&P 500 futures when the S&P moves +1% and vice versa — in this case volatility is suppressed.
So what you mean by that is, when dealers are net positive gamma (total put and calls gamma) they are above zero gamma or vol trigger according spotgamma source? and till price don’t go below zero gamma, dealers sell futures as the market goes up or buy futures when market go down?
I found your articles after trying to find out why S&P 500 market gamma models ‘assume’ dealers usually are net short puts, and long calls. Based on your response to Anthony, it appears you assume the same. I am confused by this assumption because data (both from OCC and spotgamma) shows that customer flows demonstrate that traders are net long calls more often that they are net short calls. As MM take the other side this means on average they are net short calls. Am I missing something, and why is this assumption being accepted when the data shows otherwise? Hoping you might be able to shed some light on it? I have asked spotgamma for an explanation but have not had any response
I think, the basic reason for that assumption is that the biggest fish in the pond traditionally are systematic covered call strategies by institutional players. Recently this may have been overwhelmed by increased retail call buying in tech / growth names. Maybe this explains the data?
It does show up in different models as more pronounced negative gamma in QQQ, while SPY gamma is positive.
I hope this helps, but would be interested in spotgamma’s take, if they ever answer…
Hey David, thanks for the reply. This makes sense considering that since covid the interest in retail options trading has definitely exploded (i keep thinking of all those who bet on sports having to find something else to bet on), and maybe it will decline over the near future. Will keep an eye on the data but for now there is definitely more calls being bought to open than sold. If I get a response from SG will let you know