Go With the Flow

Can you predict short-term movements in the underlying stock market using option gamma hedging?

A growing community of traders believe you can … and they may be on to something.

The mechanism by which options markets directly influence the underlying stock market is dealer hedging.

Essentially, dealers (or professional market makers) are counterparty to roughly 95% of all options trades. Given that dealers don’t like to take market risk, all of this flow has to be hedged, and the way that it is hedged has changed in recent years.

It used to be that the options market was dominated by large ticket trades vs financial institutions and the market maker had various tricks for hedging out that risk, often done manually by the trader.

Those types of trades still exist but they are increasingly being dwarfed by the influx of smaller, short-term, ‘retail’ flow. This ocean of small trades, with one day or less until expiry, has changed the business of market making.

If your book is dominated by 0day contracts with huge gamma risk, the only way to hedge (apart from crossing the spread yourself) is dynamically buying and selling futures contracts.

The dealer’s algos will systematically hedge the ever-changing overall delta position using futures. Therefore, if you know what the dealer’s book looks like, then you can predict what their futures trading activity will be.

Of course, a lot of this is guess work because you can’t know exactly what the dealer’s book is, it has to be reverse engineered from the public tape, but there are certain clues that indicate who traded what. Also, by ‘dealer’ I am referring to the sum of all the market makers active in one market (i.e. the position that they hold collectively).

So, the key question is, how influential is this flow? Can it really drive the underlying market?

There are studies out there that seek to quantify this effect and, after reviewing much of the evidence, I think the answer is … “sometimes, a bit, and in different ways”.

This is a big topic, so I plan to unpack it over multiple posts.

But to summarize how big these flows can get; we estimate that market makers in the NDX or QQQ options can represent up to 10% of the volume in the E-mini Nasdaq 100 future. Which can be significant, especially if others are watching it and piling on in the same direction.

The effect is often most prevalent at the end of the day, and often on days which are otherwise quiet but have big, concentrated options positions expiring.

The effect also presents in different ways. Sometimes it can ‘pin’ the underlying market to a particular level; sometimes it can dampen volatility and keep the market range bound; and sometimes it can increase volatility leading to exaggerated price trends. When this happens it is referred to as a ‘gamma squeeze’, but this is just an extreme example of something that is happening all the time, on a smaller scale.

In the next post I will give examples of this and show why it happened and what the impact was.

Stay tuned!