Go With the Flow: Part II

Now we know that market makers hedge and re-hedge their options positions in the underlying market for their near-to-expiry contracts, the next question is “what impact does all that have on the underlying price?”

Let’s take a look…

The first thing to note is that – contrary to some reports – the impact of 0DTE options is mostly to suppress market volatility, rather than increase it.

Why?

For equity indices like the Nasdaq 100, market makers are generally long gamma at-the-money. That means that customers, or traders, are generally net sellers of short-term ATM options, and market makers are therefore generally net buyers. 

This is not always the case, but it is the most common state of affairs (I am not sure exactly why so many people are selling ATM options. I would guess it’s mostly covered calls or dispersion traders, rather than speculators selling naked options and hoping for the best).  

If MMs are long gamma, i.e., they hold net long positions in options (both puts and calls), then the impact of their hedging will be to reduce market volatility. 

If they are short gamma, then their hedging will increase volatility.

I won’t bore you with the details of precisely how gamma hedging either increases of decreases volatility. If you are interested, Investopedia do a very good job of that (https://www.investopedia.com/terms/d/deltagamma-hedging.asp#:~:text=Assume%20that%20the%20gamma%20on,then%20delta%20is%20now%200.8). 

The important thing to note is that mostly it’s suppressive. However, in situations where the market is falling and the price approaches previously bought put strikes (where the dealer is net short puts) then the impact of the dealer’s hedging will be to push the market even lower, thereby deepening routs.

However, one element of short gamma that is not often mentioned is that, although it can accelerate the market on the way down, it also accelerates the recovery on the way up. If dealers are short gamma, that means they will be buying more futures when the market eventually turns, which can help propel the price back up again. 

But it isn’t just gamma that market makers need to dynamically hedge. The passage of time can also change the delta of an option. For every derivative of change in something over change in something else, traders have lovingly bestowed a name. Change in delta over change in time is referred to as ‘Charm’.

Charm is interesting because it creates trends in the market. As the delta of an option approaches either 0 or 100 in the hours before expiry, market makers have to adjust their hedges, even if the underlying market isn’t moving. This has the effect of pushing the market in one direction or other, depending on the make-up of the dealer’s portfolio. 

Charm also has another interesting effect, which is to ‘pin’ the market.

Imagine you are a dealer and you are long a call option in size, there is only 30 minutes left until expiry and the market price is just above your strike. 

That option is in-the-money, which means that its delta is rapidly approaching 100. In order to hedge it you need to sell futures, but in doing so you push the market down, below the strike. Now that option is out of the money and its delta is rapidly approaching 0, so you need to buy back your hedge and in doing so you push the market back up again, past the strike. 

You can see how this under and over shooting can cause the market to ‘pin’ at the level of the strike, all else being equal. This happens where the dealer is either long a call / put, or it can happen in between the strikes of a vertical call / put spread.

By knowing what the dealer’s book looks like, it is possible to anticipate these flows. That doesn’t mean you can always predict price movements, as these flows are often relatively small compared to the overall volume, but from time to time it may give you a slight edge in the random walk that is public markets.