How Gamma Exposure Works: Unraveling the Dynamics of Risk Hedging
December 13, 2023
Understanding how big players in the market use Gamma Exposure can provide an enormous edge to your trading strategy.
Why?
Option dealers, often referred to as market makers, play a crucial role in financial markets by providing liquidity and facilitating trading activities.
Dealers and other big market players engage in dynamic hedging strategies, known as “Delta Hedging”, to manage the risks associated with the option positions they hold.
Enter: Gamma Exposure
Gamma exposure or “GEX” is a key parameter in the risk management of not only option dealers, but any portfolio manager that heavily incorporates option overlays into their strategy.
So, understanding how these big players in the market use GEX to hedge themselves is essential for navigating the complexities of options trading and short term market direction.
So how does Gamma Exposure work?
To understand GEX we first need to understand the basics of gamma.
Gamma, known as the second derivative of an option’s price with respect to the underlying asset’s price, adds a layer of intricacy to the dynamics of options trading. Delta, the first derivative, measures the sensitivity of an option’s price to changes in the price of the underlying asset.
The nature of option pricing has an element of convexity, which means prices do not move linearly up or down. The graph below illustrates the convex nature of option pricing related to gamma.
Gamma is highest as price approaches the “At The Money” strike, increasing exponentially as it is approached from either direction. So, gamma is essentially measuring the rate of change or the acceleration of an option’s delta and hence, an option’s price.
To hedge against delta risk, option dealers and other big market players must dynamically adjust their positions in the underlying asset. They do this by measuring GEX levels which shows how their portfolio will be affected as price moves towards various strike prices, based on gamma-fueled price acceleration.
We can implement analysis similar to that of option dealers, by measuring GEX for the entire market or for specific stocks.
Below is an example of the Gamma Exposure for the S&P 500. We can clearly see where the big players in the market are concentrated, and thus where the most hedging activity will likely take place, based on gamma exposure.
Big gamma concentrations often act as magnets, drawing price into them. Once reached, they can also act as support or resistance levels.
This is driven by the way big market players have to hedge:
Positive Gamma Environments
It is generally assumed that option dealers are buying calls as investors sell calls for the purposes of generating income in their portfolios. In positive gamma environments, these dealers then hedge their long call positions by selling the underlying security (or futures in the case of the S&P 500) as price moves higher and by buying the underlying security as price moves lower.
Delta hedging flows in positive gamma environments can have a large impact on market structure, creating a stabilizing effect on markets. Volatility typically compresses in these environments.
However, we also see that portfolio managers employing option overlay strategies are also active on both sides of the options market, which can fuel further gamma concentrations at certain strike prices. In positive gamma environments this ‘clustering’ at higher strike prices helps drive the underlying security (or Index in this instance) higher in what is known as a positive feedback loop.
In these cases, call buying at higher strikes overwhelms dealer selling of the underlying security (or futures) at the current price, which pressures the market higher. This is one reason why we often times see markets drifting higher in highly positive gamma environments.
Negative Gamma Environments
On the flipside, it is generally assumed that option dealers are selling puts as investors buy puts for the purposes of protecting their portfolios against big selloffs. In negative gamma environments, dealers then hedge their short put positions by selling the underlying security as price moves lower and by buying the underlying security as price moves higher.
These delta hedging flows can also have a structurally large impact on the market, creating a negative feedback loop effect, and volatility typically expands in these environments in both directions.
At the same time, we also see that portfolio managers with option overlay strategies are still active on both sides of the options market, which can again fuel further concentrations at certain strike prices. In negative gamma environments this ‘clustering’ at lower strike prices helps drive the underlying security lower.
Tremendous put buying across the market combined with general selling and dealer selling sends the market reeling lower. These negative feedback loops often culminate in capitulation events during extreme negative gamma environments.
Based on whether the market is in a positive or negative environment, gamma can exacerbate moves causing volatility expansion (negative GEX) or reduce movement causing volatility compression (positive gamma).
Another important point in the GEX spectrum is known as ‘Zero Gamma’. Zero Gamma is the level in the options market where gamma flips from positive to negative and vice versa.
Knowing where this level is can help us identify whether we are ‘flipping’ or transitioning into a positive or negative environment for the particular stock or index we’re analyzing.
GEX Spectrum
Another important metric that should be considered are the GEX levels relative to historical ranges. Since we can estimate GEX for every security with a decently liquid options market, we can also estimate the historical GEX range for each security as well.
Take for example the SPY. As of the time of this writing, SPY’s GEX spectrum can span anywhere from approximately -4 billion Total Net Gamma to +4 billion Total Net Gamma.
Analyzing the historical GEX range allows us to know how stretched current gamma exposure levels are relative to the security’s ‘GEX Spectrum’. If gamma exposure is at an extreme level relative to historical ranges, the security’s price may be at an important turning point.
Here’s a quick example to illustrate. Towards the end of October 2023, the market was nearing extreme negative gamma readings, having sold off approximately 10% since late July. By October 27th, SPY was at an extreme reading approaching nearly -3 billion in net negative gamma.
That date proved to be a major low in the market, with SPY subsequently rallying nearly 15% over the coming weeks.
The market has had many of these extreme gamma events just within the past few years. We also see these extremes occur quite regularly in individual stocks like TSLA and NVDA for example.
It’s clear that measuring Gamma Exposure is an important edge in both equity and option strategies, so we’ve built a user friendly dashboard that provides important real-time GEX data. We’ve also added a way to view GEX levels relative to historical ranges for each security we track through our GEX Intensity Gauge.
Gamma Exposure is a multi-dimensional beast that can dramatically impact the market’s short-term direction. Understanding how gamma works, analyzing positive & negative gamma environments, measuring GEX levels, and reviewing the historical ranges can give you a significant advantage in formulating your overall trading strategy.
If you’re interested in stepping up your trading game through GEX tools and analysis sign up to access our GEX Dashboard at geeksoffinance.com. You can also follow us on X (Twitter) or YouTube.
