Disclaimer: The above chart is entirely fictitious to get the points across.
What are gamma levels and why are they significant?
Let’s make a couple of assumptions:
1) The SPX option market is primarily used for hedging purposes by big investors.
2) Those investors hedge downside-risk by buying put protection (that’s a “long put”) and selling calls (short calls).
3) On the other side of those trades are the so called option dealers (ODs), who buy calls (long calls) and sell puts (short puts).
Option dealers do not want directional risk, so they delta-hedge their exposure away right after the initial trade. Both the long call and the short put positions are bullish, so they need to initially sell futures against them.
So far pretty straightforward, but here is where it is getting a little tricky..
Option delta changes when markets are moving, and therefore ODs have to adjust their initial delta hedges frequently (especially when an option moves into/out of the money, due to fast delta changes) but the mechanics are different for longs calls and short puts.
Scenario 1): Assume the OD only has one long call to hedge:
A long call has a positive gamma value, and when the option moves into the money as the market goes up, gamma increases (delta accelerates from 0 toward 1), which forces ODs to sell even more futures above their initial delta hedge. (As for the opposite direction: If the option moves out of the money, gamma spikes again and ODs are forced to buy futures).
In plain english: If an OD is long gamma (for example if he owns more long call options than short puts OR his long calls are getting pushed into the money, while his short puts leave the money), he is buying when YOU are selling and selling, when YOU are buying.
Scenario 2): Now let’s assume the OD only has one short put option to hedge:
A short put has a negative gamma value and when the option moves out of the money as the market declines, gamma becomes even more negative (delta accelerating from 0 towards 1), which forces ODs to sell more futures beyond their initial delta hedge. If the market is moving up and the short put moves into the money gamma spikes again, but this time around delta delta declines towards 0 and ODs can unwind hedges by buying back futures.
Again in plain english: If an OD is short gamma (if he owns more short put options than long calls OR if his short puts are moving into the money), he is selling, when YOU are selling and buying, when YOU are buying.
Tip: It is mind bending to wrap your head around those concepts at first, but I suggest to keep looking at the option characteristics of long calls and short puts while trying to digest the concept of delta hedging. It is not per se hard to understand if you just memorize the corresponding charts.
If you do not care about options at all, just remember that if an option dealer is long gamma he is suppressing volatility due to his counter cyclical hedging approach and if a dealer is short gamma he is trading “with the flow”, therefore increasing volatility.
A question many are asking is: How do we know if option dealers are long or short gamma and how do I come up with those “gamma inversion levels”?
In order to calculate the net dealer position at the current market price, all you need to do is to add up the gamma of all call options and subtract the gamma of all put options from that number.
Now, in order to estimate the gamma inversion you just need to to run a couple of iterations that simulate a market drop and..Voila.
I am writing this up super fast and I hope I’ve made no major flaw. Many people are interested and keep asking the same questions and I am very slow to respond to private messages, so I figured I just give you a full broadside.
What are gamma levels and why are they significant?
Let’s make a couple of assumptions:
1) The SPX option market is primarily used for hedging purposes by big investors.
2) Those investors hedge downside-risk by buying put protection (that’s a “long put”) and selling calls (short calls).
3) On the other side of those trades are the so called option dealers (ODs), who buy calls (long calls) and sell puts (short puts).
Option dealers do not want directional risk, so they delta-hedge their exposure away right after the initial trade. Both the long call and the short put positions are bullish, so they need to initially sell futures against them.
So far pretty straightforward, but here is where it is getting a little tricky..
Option delta changes when markets are moving, and therefore ODs have to adjust their initial delta hedges frequently (especially when an option moves into/out of the money, due to fast delta changes) but the mechanics are different for longs calls and short puts.
Scenario 1): Assume the OD only has one long call to hedge:
A long call has a positive gamma value, and when the option moves into the money as the market goes up, gamma increases (delta accelerates from 0 toward 1), which forces ODs to sell even more futures above their initial delta hedge. (As for the opposite direction: If the option moves out of the money, gamma spikes again and ODs are forced to buy futures).
In plain english: If an OD is long gamma (for example if he owns more long call options than short puts OR his long calls are getting pushed into the money, while his short puts leave the money), he is buying when YOU are selling and selling, when YOU are buying.
Scenario 2): Now let’s assume the OD only has one short put option to hedge:
A short put has a negative gamma value and when the option moves out of the money as the market declines, gamma becomes even more negative (delta accelerating from 0 towards 1), which forces ODs to sell more futures beyond their initial delta hedge. If the market is moving up and the short put moves into the money gamma spikes again, but this time around delta delta declines towards 0 and ODs can unwind hedges by buying back futures.
Again in plain english: If an OD is short gamma (if he owns more short put options than long calls OR if his short puts are moving into the money), he is selling, when YOU are selling and buying, when YOU are buying.
Tip: It is mind bending to wrap your head around those concepts at first, but I suggest to keep looking at the option characteristics of long calls and short puts while trying to digest the concept of delta hedging. It is not per se hard to understand if you just memorize the corresponding charts.
If you do not care about options at all, just remember that if an option dealer is long gamma he is suppressing volatility due to his counter cyclical hedging approach and if a dealer is short gamma he is trading “with the flow”, therefore increasing volatility.
A question many are asking is: How do we know if option dealers are long or short gamma and how do I come up with those “gamma inversion levels”?
In order to calculate the net dealer position at the current market price, all you need to do is to add up the gamma of all call options and subtract the gamma of all put options from that number.
Now, in order to estimate the gamma inversion you just need to to run a couple of iterations that simulate a market drop and..Voila.
I am writing this up super fast and I hope I’ve made no major flaw. Many people are interested and keep asking the same questions and I am very slow to respond to private messages, so I figured I just give you a full broadside.