Why Trading Options Can Cause Stocks to Volatilize

Options trade a little differently than stocks. When you open an options contract, you may be trading with a market maker rather than another individual investor. You and your counterparty (usually the market maker) create the options contract – both the assets and the liabilities they entail – presumably from scratch under standardized contracts.

Market makers do not enter into these trades out of kindness, but rather to profit from trading. The market maker usually uses a sophisticated pricing model called the Black-Scholes Option Pricing Model to figure out what the option should cost.

The price at which the market maker becomes Effective Trade with you usually results in a statistical profit based on this pricing model. Additionally, the market maker will likely use some of this potential profit along with other capital to hedge their bets by buying stocks or selling short, whichever option they choose, if the market moves in the wrong direction. Far from the point of view of this market maker. It is this hedging activity that can create the conditions for gamma compression.

For me everything is Greek

The Black-Scholes model doesn’t just spit out a price for an options contract. It also allows several risk measures to be calculated based on this price, collectively known as the Greeks. One of these Greeks – known as Gamma – is often used by market makers to determine how much to hedge their bets.

The higher the gamma, the larger the stock position the market maker needs to effectively hedge against open option positions. As a result, market makers with open option positions often change when the gamma changes force them to buy or sell the underlying stocks to properly hedge their books. Large amounts of this forced buying or selling activity cause gamma compression.

Where does gamma come from?

To understand gamma, you must first become familiar with delta options (another Greek) which represents the expected change in the price of an option based on changes in the price of the underlying stock. For example, if a Call Option has a delta of 0.2, its price should increase by $0.20, which corresponds to a $1 increase in the underlying stock. The delta of an option changes depending on the difference between the stock price and the strike price of the option and in which direction.

The following chart shows an example chart of what an option delta chart would look like for a long call option on a stock. A long call option gives its holder the right to buy 100 shares at a certain price, while the option writer has a mutual obligation to sell those shares at the strike price. Looking at the chart, the option delta is an almost flat line around zero when a stock’s price is well below the option’s strike price. It is also an almost flat line around 1 if the price of that stock is well above the strike price of the option.

Chart by author.

In the middle, however, this delta chart curves upwards reaches a value of 0.5, and reaches its steepest slope exactly at the strike price of the option. It is the slope, the descent of the delta diagram of the option, which shows the gamma of the option, and this slope – and therefore the gamma – is steepest exactly at the strike price of this option.

What can create the conditions for gamma compression?

In the case of GameStop, many people have long expected the company to be forced into bankruptcy thanks to a business model largely disrupted by digital game downloads. Expecting bad news like this may tempt investors to borrow and sell the stock. So many people had made this decision about GameStop over 100% of the company’s total float had been sold short once.

Because of the potential for a short squeeze, many investors selling stocks short are not just selling a stock, but rather covering their short positions by buying long, out-of-the-money, contrarian calls (ie the strike price of the call is greater than the price of the shares traded at the time the calls were purchased). For example, let’s say an investor cut 100 GameStop shares for $10 a share in October 2020. That investor could have purchased a $15 call option to hedge that bet at a fairly cheap price at the time. will be.

This would have shielded the investor from brief pressures that would have driven GameStop’s price up, at the expense of some potential gains if the company’s shares continued to fall to zero. The market maker on the other side of this options trade would likely have used a gamma calculation to determine how many GameStop shares to buy to set up a hedge.

The GameStop Short Squeeze is in full swing in January 2021. GameStop’s tough fundamentals haven’t improved dramatically, but the stock price is much higher thanks to the short press. This higher share price attracts even more short sellers who want to take advantage of the even greater distance that GameStop shares are traveling.

In turn, these new short sellers are buying longer call options on the silver to protect against the possibility that their stocks will continue to rise. Adding to this pressure, speculators betting on the stock, continuing their rapid run, may also be buying out-of-the-money calls in hopes that their bet pays off. Especially when there is not much time left for these call options because they are about to expire, the risk/reward trade-off can be very tempting.

This forces the market maker on the other side of the options trading to make him buy more shares to hedge, which, in turn, causes the stock to continue to rise. If the stock goes up to get closer to that strike price, the market maker is forced to buy even more shares as a gamma hedge and you get gamma compression.

What goes up is very likely to come down

The most important thing about Gamma Bruises, however, is that they are often very sharp double-edged swords. Just as you can force buy They can also force sell Print. Remember that the gamma is based on that plot of that delta chart above, and that chart has the steepest slope (and therefore the highest gamma) exactly at the option’s strike price. If you move too far away from this price, the gamma will start to fade, reducing the pressure to hedge (and often even reversing it).

Similarly, the market maker no longer has to hold a hedge against an option position that no longer exists if those options contracts are entered into, exercised, or expire. It also reduces the buying pressure on the stock, which can cause the pressure to reverse.

Regardless of what drives their eventual reversal, Gamma Bruises won’t last forever. And when they reverse, moving in the opposite direction can be just as painful (if not more) than the initial pressure itself.

In either case, the volatility during and immediately after gamma compression is usually extreme and the predictability goes right out of the window. Whether GameStop or another company undergoes gamma compression, it might be better to wait until the end. Once that’s over, you can look through the remaining wreckage and see if it offers you an investment opportunity that you want to take advantage of in the long run.

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