There is a new buzzword in town: ‘Gamma Flip’. It is used to explain (due to a lack of any sane explanation for current market behaviour) why the S&P seems stuck at practically all-time highs and what might happen if things turn bad. In fact, it is so hot that even TV pundits are elaborating on its potential advantages and dangers. But what exactly is it?
Gamma as a thing has been around since traders began to use options to hedge, speculate, and mitigate risk. But it was not until the shiny Black-Scholes model emerged in the ‘70s that anyone knew what to call it. Bluntly, gamma is the first derivative of the option delta and describes the sensitivity of the delta in relation to price movements of the underlying security. A flip is the transition from a prior (in this case positive) state, to its opposite (now negative) state. For many that’s hardly an eloquent answer, nor even a particularly explanatory one. Of course, there is a far easier way of describing gamma (and the potential flip it implies), but to reveal it would rob derivatives experts of their inordinately rotund paycheques… Luckily for you, nobody is paying me to be pretentious anymore.
The majority of investors own equities. Only a few short them to make a living. Pension funds, asset managers, or family offices sit on large equity holdings producing (apart from anxiety) dividends. And that’s pretty much it. But there is a way to squeeze some additional returns out of your existing positions: namely, selling call options above the current market level. The logic, especially after a long bull market, goes as follows.
Let’s say you are sitting on rather good performance figures by holding a market portfolio. The market went up for a long time. That’s awesome. However, you think the air is getting thinner up there and expect a market correction is around the corner. Maybe there is room for another 10%, but that’s it. So, you think to yourself, ‘why don’t I start selling my holdings potentially 10% above the current level?’ To achieve this, you can sell call options at levels above the current market to some unfortunate market maker (dealer) at a big financial institution. If the market does rise another 10%, you will fully participate up to that point and will have generated additional income through the option premium received for selling to the friendly market maker the privilege of participating on the spoils above the unlikely up move.
To add insult to injury, you will ask the poor sap at the same time for a price to protect your portfolio against a market drop and buy some ‘crash protection’ (e.g., put options). That will show him. With a lot of supply on the upside and increasing demand on the downside, prices for calls will fall and prices for puts will increase. This is what is called an investment skew and you can observe it in every equity options market and sometimes also in a commodities market (this tells you some very interesting things about market conditions but is a story for another column).
So far, so good. You have sold some potential upside performance against a fee and hedged yourself against some downside risk. You are still interested in a positive market development and want to be long overall.
The Advantages of Being Long
However, the market maker does not share your inclination. He wants to be market neutral; he is not payed to take any directional risks and abhors the idea of predicting anything other than volatility (I should know, I used to be one of them).
Now when you own options, you are ‘gamma long’. Gamma long is pretty cool, especially for market makers. When markets move, a long gamma will always work in your favour no matter whether you own calls or puts or both. If markets are rising, you suddenly become long. If markets decline, you are suddenly short (well, not really suddenly – you can actually calculate by how much, but for argument’s sake let’s say that is what happens). Unfortunately, you will have to pay for that privilege by losing gradually the stored time value in your option position, the so called ‘theta’.
The good news is you can actually earn it back if markets move. If you are long call options at let’s say 3150 points in the S&P (i.e., the level of the S&P as of writing), every further move to the upside increases your long position and your theoretical profit. To lock this profit in you sell on up moves and you buy on down moves, adjusting your market maker book back to neutral. If there are a lot of market makers around who have been forced to bid for call options, this is exactly what they are doing. All of them, all the time.
Suddenly this level become very sticky. Every bit of volatility is being used to recover the lost time value of the options that the market makers are now sitting on. And as these positions slowly waste away, the urge to compensate for this by hedging with every little move becomes stronger, slowly bringing the market to a standstill.
Due to the nature of gamma, these points are largest where the most options have been sold and bought. And they are easily trackable with a quick check of the open interest. The further the market moves away from these inflection points the less gamma is in the market, decreasing the urge to hedge all the time. It’s like wading through a swamp; once the market clears it, things start happening again.
Watch the Market Makers
So why do markets move at all if gamma is, like in this example, the big decelerator? Because it depends who owns it. Market makers use their gamma because they must. There is nothing worse than sitting on a position and bleeding white over time as your options deteriorate. Institutions, on the other hand, do not have to get panicky as they benefit on their sold upside positions over time and use their long, protective position to the downside to insure their portfolio. If they were to do the same as the market makers – trade in and out of positions to utilize their long gamma – they would become neutral, which is clearly not what they wanted by setting up this position in the first place. So, the market downside is now defined by institutions who do not use their long gamma, which would make the market sticky but by market makers who are gamma short.
You remember what I said about long gamma being cool? Well short gamma is terror. If the market moves against you, you will always have to do what you do not want to: shift your positions to neutral. In a falling market you are suddenly long; in a rising market you are short.
We have already covered the long side of the market and deduced that things get a bit sticky there because market makers have to sell when markets rise and buy when markets fall. The opposite is now true on the downside. With markets gathering speed towards one of the lower inflection points, the same market makers who had long gamma on the upside now have to compensate for their short gamma positions, which actually means they have to sell when markets are low, sell a bit more when they get lower, and sell a shitload when the market tanks. What used to facilitate a sticky market on the top is now cause for a very slippery market on the bottom.
The expression ‘gamma flip’ simply describes the point where long gamma positions of those who use them turn into short gamma positions for those who actually would have a need to use them, but don’t have them. In other words, it’s the point in the market where you want to step back and graciously wait until the forces of good and evil have battled it out and more sane explanations like macro factors, corporate earnings, or illusive trade deals make the headlines again. That’s it. That’s the simple explanation.
What I haven’t told you is that gamma also reacts in mysterious ways in relation to time, volatility, and distance to spot markets. But that must wait for another column. In the meantime, the gamma flip is supposed to happen at levels of roughly 3070 points in the S&P. Of course, it might just slowly fade away while we see new highs. If you read this column at some future date, we will know what has happened.
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Thorsten Roland Wegener spent twenty years trading equity derivatives and was a partner at Bear Stearns. Currently, he teaches as well as cooking, driving, and cleaning lots.