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Gamma

An introduction

Gamma, and more specifically the options dealers' gamma exposure, is the most complex topic conceptually and mathematically but it is important for our outputs - especially on Intraday charts and for short term trades.

In essence, most options markets are primarily served by market makers (dealers) who provide inventory; i.e. most of the time when you buy an options contract you buy from a dealer, not another market participant like yourself.

Typically, market participants buy options (and of course the underlying stocks) because they have a directional view on the market - e.g. they think price will go up, and options are a cheaper/leveraged way to get exposure to that move.

Dealers, however, typically need to remain neutral to moves in the underlying market; i.e. whatever options they have sold to market participants the dealer's aim is to be immune to any price movements up or down.

To achieve this, they must hedge their exposure by buying or selling shares of the underlying to cover their exposure.

A simple example

For example, if you buy an options contract with 50 delta, there is an assumed 50% chance of expiring in-the-money. If that happens, the dealer (your counterparty) must deliver you the 100 shares at the strike price, irrespective of what the actual price of those shares will be at the time. The dealer hedges this risk by buying some shares now - 50 shares for the 50% probability.

If the price of the shares goes up, your call delta will increase, e.g. to 75. The dealer must further hedge this increase risk of having to give you 100 shares by buying some more now to cover it - an additional 25 shares making 75 total to match the 75% risk of this happening.

Essetially the dealer is compelled to buy or sell shares, based on a function of the stock price and of their exposure to options contracts they have sold.

It is this mechanical buying which gives a predictive edge in short-term moves in stock price.

I.e. we can know (or approximate) their net exposure, and we can see price in real-time, so the dealer's need to buy/sell can be inferred.

That can be used in a quantitative model to predict likely areas of support/resistance based on the dealer's changing need to buy or sell as price itself moves.

Its not quite that simple underneath

Of course its not that easy in reality. Reality is much more muddy because...

  • not everybody buys options; some participants may sell short instead
  • not every options trade is with a dealer
  • options are largely sold in combinations; e.g. spreads which may have a short contract at one strike and a long contract at a farther out strike.
  • the dealer only has to hedge their net overall exposure
  • the dealer may hedge against other instruments, not just the underlying - e.g. futures contracts
  • there may be multiple dealers in a market, all of whom may have different exposure and different hedging rules
  • each market is not independent; shares move together because of mechanical flows from ETFs/indices and other participants arbitrating any divergences

And, the best/only data to approximate dealer exposure from is daily open interest data from the options exchanges; intraday data only shows flow (e.g. "500 calls traded at price X") - not how this affects overall open interest. Open interest itself is also a sum of all open contracts for each option, some of which will not have a dealer on the short side.

But that doesn't really matter

Nevertheless, most participants buy options, and most trades have a dealer as the short counterparty, and most hedging is against the underlying stock.

So, with a robust quantitative model, decent levels can be computed on a daily basis that form good indicators for where levels of support/resistance can occur. Plotting these visually on a chart can greatly enrich the understanding of price action.

Long/short gamma

At an overall level, for a given underlying price, dealer exposure can be seen as 'long gamma' or 'short gamma'.

When dealers are long gamma, their hedging flows tend to dampen market movements - in either direction; i.e. a big move up would trigger dealer selling, which suppresses that upward price movement. And the same for downward moves.

When dealers are short gamma, their hedging flows tend to exacerbate market movement; i.e. a move up causes the dealer to buy, pushing price futher up and causing more hedging which pushes price further up. And the same for downward moves; triggering dealer selling.

As such, understanding the overall gamma regime can help interpret whether price moves are likely to sustain/accelerate or mean-revert.

Gamma exposure is different, for the same net exposure, at different price levels. There is therefore a price level where dealer gamma exposure is neutral. This gamma neutral point should be seen as a place of balance or uncertainty

Relevant levels

But there are no certainties in markets

These are mechanical levels, with a degree of influence on how price can move. But fundamental factors that change sentiment on a stock, a sector or the equities market as a whole can have a far larger influence in the short and long term.

E.g. an FOMC announcement with a surprise change to interest rates. This can have a far larger effect in causing institutions to adjust their positioning that any options dealer's hedging activity is dwarfed.

There are many other fundamental and other factors that can influence how effective predicted support/resistance levels based on dealer gamma can be - so they should be used with care and contextual awareness only; with an eye to the daily chart, to VIX, to fundamental/economic news, and more.