What Gamma Isn’t

Some months back I published an article explaining the so-called Gamma-Flip. It was just when it became fashionable to use terms firmly anchored in the world of derivatives to explain market behaviour, rather than traditional valuation indicators which now appeared to lack explanatory power. I provided a fresh view from ‘left field’, the weird and wonderful world of option trading. Little did I know that my Macro Hive article would be picked up by various publications from Chicago to Mumbai, capturing a zeitgeist in the market.

 

Gamma as Swiss Army Knife?

Since that 15 minutes of fame I have read a lot of articles invoking options gamma as a force to explain almost any move imaginable – from stalling major indices to parabolic moves in certain (unnamed) electric car manufacturers, as well as explaining the diametrically opposed moves invoking the same underlying forces. Even though I love my professional field, namely derivatives in all shapes, forms, or sizes, gamma is only one factor that can explain certain situations. It’s not the swiss army knife that many market pundits find it so fashionable to portray it as.

 

Understanding Equity Highs

Market have always and will always (in the long term) obey fundamental principles. On occasion, it takes a bit longer to realize were markets should be, compared with the state they are actually in. But eventually logic will prevail. Gamma plays an important role to assess the technical situation of specific markets, not the strategic outlook for those markets.

At the moment, equity markets are considered to be priced at the high end of historic valuations, and explanations are needed to reconcile the seemingly never-ending expansion with a classic longer-term view of free markets as a pricing mechanism for economic output. An unprecedented low global interest rate environment has dramatically increased liquidity in the search for an outlet and sustainable returns amid an uncertain future. In a marketplace where liquidity plays an important role, taking option markets and their influence into consideration can be a useful tool.

 

Gamma as Accelerator and Brake

This is where ‘Gamma Talk’ enters the equation. So, what does gamma do?  Gamma can, but doesn’t have to, add liquidity to a market. If that pesky little gamma is considered to be ‘long gamma’, it might have a stalling effect on the direction of security markets. And if it is considered to be ‘short gamma’, it can have an accelerating effect on the direction of specific securities.

This is true for both sides, up as well as down. If, for example, a rising market fuelled by liquidity encounters additional supply at a certain price level, its rate of change might slow down, stop, or even reverse its direction. This additional supply can be generated through option markets.

Investors with long positions enjoy selling options at higher prices compared with the current market level. This is especially so after a long bull run, whose future is uncertain at best (suicidal-risky at worst). This allows an investor to collect additional income by selling call options on an existing portfolio while still benefitting from an increase of the value of this portfolio until the level they sold is breached.

As everything that has been sold had to be bought by somebody else, this buyer wants to get his or her money’s worth. If you pay a premium for call options and you are not a buy-and-hold investor, you are most likely a professional market maker in one of the fine smaller and larger financial institutions on Wall Street, in London or in Reykjavik. What all these professionals have in common is their understanding of the mechanics of options.

 

How Delta Fits Into the Picture

Options, if out of the money (we’ll say north of the current price levels) represent only a fraction of the real thing, the security to which they are linked. This fraction is called the delta and represents roughly the probability for the purchaser of the call option to make money with such an instrument.

In our example, rising markets will now lead to a higher probability that the buyer will eventually profit from these options. The delta, as a yardstick for probability, will go up, increasingly emulating the price behaviour of the underlying security. It is now more probable to generate profits and, as if by magic, someone provided the owner of the call option with additional shares, which now can be sold into the market, generating additional liquidity.

 

Market Liquidity

And this liquidity might have an impact on the tactical situation of the security in question. Might. It doesn’t have to. If a favourable outlook for a security meets increasing volume, it is very possible that, to quote General George Patton referring to German troops on the Rhein in WWII, prices will go through these gamma generating levels, lovingly called a ‘gamma wall’, like ‘a warm knife through s..t’.

If the natural trading volume generated by rational investors in their quest to  find a new price level cannot absorb excess liquidity, the increase might come to a halt – until new buyers with an even more favourable outlook slowly chip away the gamma-generated extra supply to find no resistance beyond this point, accelerating the directional move. Whether the aforementioned ‘gamma wall’ is made out of concrete or drywall is very much a function of market sentiment and liquidity.

 

Negative (Short) Gamma

The same mechanism holds true for negative gamma. Now, excess liquidity is sucked out of the system. Where sellers desperately need buyers or vice versa, the gamma takes it away. Market makers, or dealers who need to buy or sell at certain levels to stay market or delta neutral (always think in terms of probability and what it implies for the bottom line), are suddenly confronted with a black hole instead of a wall, therefore amplifying sharp moves to the upside (Tesla, anyone?) or downside. The good news: on the other side of the black hole, markets usually calm down.

 

Bottom Line

Gamma is not the secret explanation for each, and every incomprehensible move observed – even though at the moment it is desperately employed to explain certain outcomes. It is helpful to know: who owns Gamma and is therefore more likely to use or not use it? What is the liquidity situation in the market? And, most importantly, what is the sentiment for the underlying security? If you can figure that out, Gamma is a marvellous tool to give indications about likely inflection points. Otherwise, stick with the fundamentals.

One last thing. As a picture sometimes explains more than 1000 words (which I have easily exceeded by now), take a look at a recent gamma distribution for Apple I produced.

 

Chart 1: APPL Gamma Distribution Exp. 20.03.2020 as of 27.01.2020

Source: Macro Hive

 

You can easily spot at which levels the walls and the black holes indicate additional supply and demand for Apple shares. You can even calculate how high this excess volume is and its relationship to the average volume traded in Apple shares. It gets better. You can even see what options trade might be most promising (it’s an iron Condor in my view). What you can’t predict is whether your elaborate calculations will definitely lead to the outcome you anticipate. So, beware of buzzwords like ‘gamma wall’, ‘vol trigger’ or ‘call skew’ thrown your way to sell an investment case. This is not what Gamma is.

 

 

 

 

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.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)