Trading Volatility's Gamma Report - Issue #2
Key items to consider when using gamma in trading
[Note: This post is being added on Substack after originally being posted on Revue (which has discontinued their hosting operations).]
Gamma is a widely misunderstood force in equity markets, so today we’re going to take some time to clear things up.
What is Market Maker Gamma and how does it move stocks?
Market Markets (MMs) are people who sell and buy calls and puts from investors. They are in the business to make money by providing liquidity rather than holding directional bets so there goal is to stay neutral on all positions. If they sell some calls options that leaves them with a short position, so they will go buy some amount of shares in the stock to neutralize their position.
The complexity arises for them as the value of those options change almost continuously, at which point they need to go out and buy or sell stock to remain neutral.
Gamma is a measure of how much the value of options change as the underlying price moves. We’re going to keep this as non-technical as possible, but if you want to go deeper on this you can do so here.
Why do people care?
The options market has become enormous thanks to various trading brokers who have made options easily accessible to retail traders. Average Daily Volume of options contracts traded has more than doubled over the past 2 years.
Equity and ETF Options Average Daily Volume
The result is that the movement of stocks is increasingly impacted by the positioning of options traders.
For example, when investors buy a significant amount of call options across the right strikes of a given stock, Market Makers will be forced to buy shares as price rises in order to stay neutral (in this hypothetical scenario Market Maker Gamma Exposure is Negative). The stocks enters a cycle where price continues to rise higher and higher until it reaches areas where Gamma Exposure is significantly diminished. Some recent notable examples from 2021 of this include $TSLA, $AMC, $CLOV, $GME, although it was a factor in much of the 2021 stock market mania.
In the other case where Market Maker Gamma Exposure is Positive, MMs are selling stock and price rises and buying stock as price falls.
The Key Measurement for Gamma Exposure
Gamma Exposure (GEX) only has an impact when it is significant relative to the number of shares traded in a give stock.
GEX provides a measurement of how many shares Market Makers must buy (or sell) in order to stay neutral as the underlying stock moves.
We measure GEX in terms of how many dollars of a security must be bought (or sold) for each 1% the stock moves.
Impact on the S&P 500
The S&P 500 is a widely watched index for U.S. stocks and we watch GEX on it closely because it provides insights on how we can expect the broader market to behave on a given day.
⭐Positive GEX leads to greater stability in price and volatility. Price often gets drawn towards large call strikes, which are generally above the current price. Positive GEX is more meaningful when it is within a continuous trend.
⭐ Negative GEX means elevated short-term uncertainty & volatility. We will generally expect larger daily trading ranges in the index.
Recent $SPX action has been indecisive and current GEX is negative. Nimble traders are defensive here with reduced position sizes, as directional moves are less predictable.
Chart below from our GEX Charts page.
SPX Gamma Exposure trend
The status of the broader market via $SPX is important in timing options plays and short-term trades.
A sustained positive $SPX GEX market makes for a much easier environment to buy speculative calls as there is more time for the calls to work and more enthusiasm in the market. Choppy or negative GEX is a much more difficult environment for traders to play in, as it requires specific targeting across individual sectors & names.
There are many different ways to use gamma exposure to vastly improve your trading. We plan to cover these in future issues of this (free) newsletter.
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Future posts:
What is Gamma Structure & How To Use It
Skew-Adjusted Gamma Exposure
Where and Why GEX Fails
Our Daily Routine
Monitoring Open Positions
What Happens at Options Expiration