Some of the crazy volatility we see in the stock market happens because stocks and the stock market are now derivatives of a derivatives market; and no, I didn’t get that backwards.
Most people have no idea this has happened, happens, will happen again and again, or how it happens, what it does to market volatility, or what it means to their trading and investing.
I’m going to change that, right now. And I’m going to tell you how to play “it.”
“It,” in this case, is “gamma.” And it’s a function of the options market.
So, first things first: options are derivatives.
In finance, trading, and investing, a derivative is a contract that derives its value from the performance of an underlying, or reference, asset or security. In the case of equity options, as in puts and calls, the underlying securities are individual stocks, or ETFs, especially market-indexed ETFs like the SPDR S&P 500 ETF Trust (SPY) and the Invesco QQQ Trust (QQQ).
Several things have changed in the options market, especially since the onset of the pandemic. We’ve seen the rise of retail traders and investors who trade equity options. There’s also an increasing number of money managers, institutional traders, and broker-dealer and bank trading desks now trading options as well. And finally, there’s the computerization of market-making dealer firms, which has a huge impact on the volume of options that get traded.
Robots to the Rescue – And Ruin
What matters in this uncloaking is what market-makers do, mostly because they have to, not because firms like Citadel Securities, or Jane Street Capital, or Goldman Sachs are evil or manipulative.
A market-maker (and I used to be one, on the floor of the Chicago Board of Options Exchange) provides a two-sided market for the securities they make a market in. That just means they have to post both a bid and an offer, at prices and a number of contracts, which they’re obligated to transact at, as part of their market making duties.
As a market-maker at the CBOE I used to make deep markets, which means I’d use my firm’s capital, I was running a hedge fund from the Floor, to both buy and sell large quantities of calls and puts on the stocks I’d trade.
If a bunch of traders came into a pit where I was trading and they knew I was a sizeable market-maker and wanted to either buy or sell a lot of calls or puts, I’d buy or sell what I wanted with them, which might be a lot. However, there’d always be a limit to how many options I’d trade because, though I had millions of dollars in capital, there was a limit to the size or exposure I’d take on. That’s the natural consequence of having a limited amount of capital and being human.
Fast forward to today.
Now, most market-makers are machines, computer-driven algorithms that perform risk-reward calculations in hundredths of a millisecond and buy and sell puts and calls in size, almost any size they’re asked to trade. That’s because the firms that run modern market-making operations are extraordinarily well-capitalized, to the tune of hundreds of billions of dollars in some cases, and let their computers fill orders at will, which for a computer means taking the other side of any trade, no matter how big it is.
Of course, these market-making firms aren’t stupid. They don’t take unlimited risk by just filling every order, and they actively hedge their lopsided exposure by automatically offsetting risks. They do that mostly by buying and selling stocks, and moreover, buying and selling futures.
The changing price of the underlying stock or ETF an option is based on naturally changes the value of the option. The relationship between the movement in an option’s price based on the movement of the underlying stock or ETF is called delta.
A delta of 0 means the underlying stock’s movement will barely move the premium of the option, if at all. A delta of 1 (deltas go from -1 to +1) means a move in the underlying stock, say it moves a dollar, will move the option price by the same amount, in this case $1.
For simplicity, delta measures the impact on the price of an option based on a change in the price of the underlying stock or ETF.
Underneath delta, there’s gamma. While delta measures the change in the relationship between an option price and the price of the underlying instrument, gamma measures the rate of change of delta.
While a change in deltas is important to market-makers, what’s infinitely more important is gamma, the rate of change of those deltas.
In the real world it works like this:
Let’s say the market’s going down, a lot of traders and hedgers are buying put options, and speculators are buying put options on the market by buying tons of put options of SPY and QQQ. Market-making firms are the ones selling all those puts and have increasing exposure to a falling market. That’s because they’re short puts and the more the market goes down, the more exposure to losses they have.
The delta of the put options market-makers have sold increases as those puts get closer to being at or in-the-money. As delta increases, the more gamma increases.
To hedge their risk, market-makers’ computers sell short underlying stocks, and in the case of the market exposure from the puts they sold on the likes of SPY or QQQ, they’ll short futures.
The extreme moves and wild volatility we often see around options expiration dates, like this upcoming big options cycle expiration date on September 16, 2022, results from what market-making dealers do.
If, in the above example, the market continues trending down towards options expiration and the puts dealers sold get closer and cross into-the-money on successive strike price levels, those dealers have to short more stocks and futures to offset their increasing exposure, and of course their selling can exacerbate any selloff, even turning it into a rout.
The opposite can happen too, when dealers are short gamma and have, using the same example, shorted futures on the way down. If, when coming into an options expiration period, even a week out, stocks rise and the market heads higher for whatever reason, the puts dealers sold will be worth less and less if the market keeps rising.
As that happens, as gamma decreases, dealers aren’t at as much risk and so start buying back the stocks and futures they shorted. Their short-covering of stocks and futures can lift the market and reduce their exposure, which is something they want to have happen, and can try and make happen.
Now you know what gamma is, and how market-maker exposure to increasing gamma forces them to hedge or try and move markets to reduce their exposure.
It’s About to Happen Again – Here’s What to Do
September 16, 2022 is a big options expiration date. Dealers are short a ton of gamma, having sold tons of puts and having seen the market fall.
If the market continues to fall this week and next week going into Friday’s expiration, dealers will be massively short gamma and have to keep shorting stocks and futures to offset their mounting exposure. That could cause a massive selloff.
On the other hand, any good news that moves stocks and the market higher could cause a rally. This includes market-making dealers trying to cause a short-covering squeeze to move markets higher and reverse their gamma exposure, by seeing the market rise enough to where the puts they sold are worth less or might end up worthless. That would let market-makers cover their short stock positions and short futures positions, which would help lift the market going into expiration Friday and make them a ton of money, because all the premium they sold all those puts for would be theirs to keep.
That’s what happens every options expiration month. And that’s why I said up top that the stock market is now a derivative market, because stocks move based on options moves, on gamma, on market-makers’ hedging and offsetting those hedges.
So how do you play an options expiration like next Friday’s when the market can selloff hard or rally like the dickens?
Easy, you do what we do in my subscription service and buy a straddle on the market.
We buy deep out of the money puts on an index ETF and closer to in-the-money calls on the same ETF.