Volatility & Gamma Report - Issue #7
Understanding the lifecycle of Dealer positioning
Below is an overview of the actions that option dealers (AKA Market Makers) take to maintain a delta-neutral book when taking on customer trades in four different scenarios: 1) Long Puts; 2) Short Calls; 3) Long Calls; 4) Short Puts.
This dealer positioning information is extremely important in understanding how options-driven flows influence market direction.
If needed, please first read about delta hedging.
Scenario 1: Investors Buy Puts
Investors buy puts as protection against their long positions.
At Trade Opening:
As dealers sell these puts and gain exposure in the form of positive Delta, they short the underlying stock to obtain neutral position.
Re-hedging:
Gamma is negative because dealers are short the options. This means dealers will buy stock as underlying price rises, and sells stock as price falls.
At Expiration:
Out-of-the-Money Strikes
The Deltas on Out-of-the-Money puts decrease as time passes, especially in the week before options expiration.
Since the decrease in delta causes a drop in their long exposure, dealers need to cut their short exposure equally to remain neutral. This is done by buying stock, which pushes price in the underlying up and away from large put strikes.
In-the-Money Strikes
For puts at strikes that are In-The-Money, Deltas increase towards 1.0 as options expiration approaches.
In those cases, the increase in Deltas would require dealers to sell additional stock. However, investors will often sell their puts as options expiration approaches, forcing dealer to Buy To Close the puts and buy the underlying stock.
“Well-Supplied Volatility”
Notice how in both OTM and ITM scenarios here, an abundance of investor-owned puts tends to generate bullish flows in the underlying stock. The prevalence of protection via puts across stocks and indices serves as a force to help stabilize the market.
Scenario 2: Investors Sell Calls
Investors sell calls to capture premium against their long positions.
At Trade Opening:
Dealers buy these calls which generates positive delta, so they sell the underlying stock to obtain a neutral position.
Re-hedging:
Gamma is positive because dealers are long the options. This means dealers will sell stock as underlying price rises, and buy stock as price falls.
At Expiration:
Out-of-the-Money Strikes
The deltas on Out-Of-The-Money calls approach zero as time passes, especially in the week before options expiration.
Since the decrease in Delta causes a drop in long exposure, they need to reduce their short exposure by buying stock to remain neutral.
In-the-Money Strikes
When calls are In-The-Money, increasing Deltas require dealers to increase their short position by selling more stock to stay neutral.
Investors who need to unwind their short call positions cause dealers to sell their calls and buy shares of stock to close.
Scenario 3: Investors Buy Calls
At Trade Opening:
When investors buy calls in speculation of rising prices, dealers buy underlying stock to offset the negative delta they got from the calls they sold.
Re-hedging:
Gamma is negative because dealers are short the options. This means dealers will buy stock as underlying price rises, and sell stock as price falls.
At Expiration:
Out-of-the-Money Strikes
Deltas on Out Of The Money calls decrease to approach zero as time passes, especially in the week before options expiration.
Since the decrease in Delta causes a drop in their short exposure, they need to reduce their long exposure by selling stock to remain neutral.
In-the-Money Strikes
When calls are in the money, increasing Deltas increase the dealers' short position and require dealers to buy more stock to stay neutral.
If investors decide to sell their calls prior to expiration rather than converting to shares, dealers are forced to Buy-To-Close their calls and sell their shares.
Gamma squeezes can be generated when investors buy large amounts of calls across a range out-of-the-money strikes that are closely spaced. This provides dealers with negative gamma that is continuously replenished as price moves higher and dealers buy additional shares as price moves higher. This is most frequently seen in scenarios where the ratio of dealer gamma exposure to daily trade volume (in shares) is significant.
Scenario 4: Investors Sell Puts
Investors sell puts at strikes to capture premium, usually against their long positions.
At Trade Opening:
Dealers are long these puts with negative delta so they buy the underlying stock to obtain a neutral position.
Re-hedging:
Gamma is positive because dealers are long the options. This means dealers will sell stock as underlying price rises, and buy stock as price falls.
At Expiration:
Out-of-the-Money Strikes
The deltas on Out-Of-The-Money puts increase to approach zero as time passes, especially in the week before options expiration.
As deltas approach zero it causes a reduction in dealers' short exposure, so they need to reduce their long exposure by selling stock to remain neutral.
In-the-Money Strikes
For puts at strikes that are In-The-Money, Deltas approach -1.0 as options expiration approaches, which increase the dealers' short position. Dealers must increase their long exposure by buying stock to remain neutral.
Investors who are short these In-The-Money puts will most often Buy-To-Close their position, which causes dealers to sell their puts and sell stock.
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