More About Gamma & Help From Eric Hale

Eric Hale is the founder of the Fintech company Trader Oasis (https://traderoasis.com). Trader Oasis is a commission-free trading platform developed for retail stocks and options traders. He is also a GIC member (https://www.interdependence.org) and a regular at the gathering in Maine (Ed. note: this gathering is affectionately called "Camp Kotok"). 
   
Eric responded eloquently to the piece I published about gamma on January 30: “Gamma?”, https://www.cumber.com/market-commentary/gamma.  
   
We thank him for giving permission to share his note with our readers. Eric, we can discuss further when I see you at the GIC conference.  Safe travels to Nassau. 

 

 

   
Here’s Eric Hale, in two parts. In his first note, Eric discusses gamma. In a follow-up, he adds definitions and further discussion that may also be helpful to readers (traders).  
 

Hello David,  

Thanks for sharing. It thrills me to hear you talk about something that I am passionate about – options. I want to share my perspective on why extreme dealer gamma is noteworthy.   

Options Greeks can make people's eyes glaze over. I think it's where the phrase "It's all Greek to me" might have come from. To make sure everyone is on the same page, delta is how a portfolio value will change based on the underlying equity. For example, a call with a delta of +0.5 would realize a $0.50/per share increase in value of the call. But when the stock moves, the delta moves, too. Gamma is how the delta changes when the [price of the] underlying changes. Delta and gamma are the first and second derivatives with respect to the stock price. Speed and acceleration are great analogies.   

Gamma is positive for all long options and negative for all short options.   
   
Gamma tends to get very high as we approach expiration and the stock is near the money. That means small changes in the underlying cause big changes in your option’s pricing. That's probably why people reference time in relation to gamma.   

There has been a lot of attention to dealer gamma lately. Dealer gamma can tell us about the future volatility of the underly equity. This is not directly related to the VIX or SKEW. Those give insight into future movements too, but they differ from dealer gamma.   

To understand how dealer gamma can contribute to volatility, look at it from the options dealers' perspective.   

No one mentions dealer delta when we are talking about dealer gamma. That is what is important. It tells us if dealers will buy or sell the stock or futures. Dealers do not take a bullish or bearish edge. They are normally delta neutral. They make their money from the bid/ask spread, time decay, and sometimes implied volatility. (We should leave time and implied volatility out of this discussion for now.)  

Dealers have a dynamic inventory of long and short calls and puts at various strikes and expirations. Because they are in the market-making business, they do not get to choose what they buy or sell. Their options inventory will give them a delta bias. This bias is either bullish or bearish, i.e., a positive or negative net delta. Their long or short position in the underlying stock or future is how they get to a delta-neutral portfolio. When their delta changes, the dealers will respond by buying or selling the underlying stock or future to get back to delta neutral.   

We look to the dealer gamma to understand if the dealer delta will become positive or negative as the underlying moves. Understanding this tells us how the dealers will respond to changes in the underlying equity. The question is, will dealers buy or sell the underlying equity when the stock moves?   

Here's a simple rubric:   
·     If dealer gamma is positive and the stock moves positively, the dealers will become delta positive. They will sell shares.   
·     If dealer gamma is positive and the stock moves negatively, the dealers will become delta negative. They will buy shares.   
·     If the dealer gamma is negative and the stock moves positively, the dealers will become delta negative. They will buy shares.   
·     If dealer gamma is negative and the stock moves negatively, the dealers will become delta positive. They will sell shares.  
   
From this, we can see that if dealer gamma is positive, it will tend to dampen the volatility of the underlying. If dealer gamma is negative, it will tend to amplify the volatility of the underlying in that direction.   

Currently, traders are selling out-of-the-money puts, and they are buying out-of-the-money calls. The market internals show this. This is a bullish sentiment from the options traders' perspective. From a dealer's perspective, this sets up a dealer gamma profile that is positive below the current price (because they are long puts) and negative above the current price (because they are short calls). Currently, these levels are extreme, especially to the upside. This implies the market could have a tear-your-face-off rally as dealers will buy the heck out of a bullish move. And we're likely to find support as dealers buy into a bearish move.   

Dealer gamma does not tell you what will happen – only what could happen. To be clear, dealers do not want to move the market. They want to keep their portfolio delta neutral and take the other side of your trades.   

For high negative gamma, I like to use the analogy of a lit candle sitting on a rickety table. There are some old newspapers, dry wood, and an open gasoline can. Everything will be fine as long as we don't make any sudden movements. If something moves, it can all go BOOM!  
  

(Image from ChatGPT Dalle-3)

Dealer gamma also changes intraday as traders open, close, and roll positions. Dealer delta is also affected by time (charm) and implied volatility (vanna.) So, understanding how dealer delta changes is a bit of a moving target. But monitoring dealer gamma gets you a pretty good picture of how the volatility could change.   

The massive growth in 0DTE options is certainly contributing to this puzzle. But that's a whole other can of worms.  

I would be pleased if you shared this with your readers. Let me know if you'd like to see any changes.   

I am looking forward to seeing you in the Bahamas in two weeks. Just stay north of Shirley Street! I assume you saw the Dept. of State warning.  

Warm regards,  
Eric

I asked Eric if he would be kind enough to define charm and vanna for our readers. He was kind enough to embellish. Here’s the result.  
   
Eric Hale added:    
 

I don't want to go too far in the weeds. But I am happy to expound.   

Charm is the first derivative of delta with respect to time. That shows how your delta will change over time – all other factors being equal. Take, for example, an out-of-the-money call. It might have a delta of +0.4. If it expires out-of-the-money, it will be worthless. As expiration approaches, the delta will fall to zero. Charm shows how the delta changes each day. For an out-of-the-money call, the charm is negative. For in-the-money calls delta will approach +1.0 on expiry. Thus, in-the-money calls have a positive charm.   
   
Vanna – not to be confused with the stunning co-host of the Wheel of Fortune – is the first derivative of delta with respect to implied volatility. It indicates how the delta changes when implied volatility rises and falls.   
   
From a retail trader's standpoint, it's probably not worth focusing on these second-order greeks. Most experienced options traders understand how their prices will change with time, price, and volatility. When I explain charm to our clients, they often say, "I understood the concept. I didn't know that it had a name." So, they don't use charm explicitly. For that matter, most don't use any of the greeks to calculate the changes. Instead, they use an options analyzer. It models the behavior of their position and provides a more precise estimate of the values. These tools are typically built into their broker's platform. The greeks are really about understanding sensitivity to those variables that affect options pricing.   
   
When considering a dealer positioning, there is a benefit to watching gamma and these second-order dealers’ greeks. For example, seeing that the dealers had very high positive charm would tell us that their delta will become positive with time. The dealers will be selling stocks to maintain delta neutral. And the same with vanna. If dealers have positive vanna and we see an implied volatility crush, dealers' delta will fall. They are likely to buy stock.   
   
The charm and vanna discussion, as it applies to dealers, is most significant for short-term options. Some of the 0DTE traders use vanna and charm to gauge how the market might swing as we move toward the end of the day.   
   
As I mentioned in the previous message, these data give us insight into what could happen – not what will happen. The market is dynamic. Traders are opening, closing, and rolling positions into the close, and the dealers are responding. The volume is massive. Last Friday saw the third largest expiration in history, with over $3.4 trillion in notional value expiring.   
   
For the record, I am not a fan of 0DTE options. At Trader Oasis, we offer tools to analyze the dealer gamma, charm, and vanna. Our clients use those data to trade 0DTEs. It's my opinion that 0DTE traders are not adequately paid for the tail risk. In response to that, 0DTE traders usually say something like, "I've been doing it for months, and it has worked for me." That's also true for turkeys on a turkey farm – until late October. (At Trader Oasis we don't provide trading advice.)   
   
I am on the same page with JPM's Marco Kolanovic that 0DTE options could cause a ‘Volmageddon 2.0.’ And as Charlie McElligott points out, that volatility could be to the upside.   
   
Please let me know if you need anything!  

Regards,  
Eric

For those readers who are still with us, this is a lot more than I envisioned when the first piece about gamma was in the drafting stage. Normally a subject like this is way too complex for the usual commentary. That said, I hope it was helpful. Many thanks again to Eric Hale and Charlie McElligott for all their contributions to our discussion.  
   
If readers like the conversation and want more "greeks", please send me an email and tell me. Likewise, if you think this is a waste of time and energy, please let me know.  Now I’m going to think about vega. But first, a nap.