By: Steve Smith
Yesterday we looked into how the willingness of investors to sell option premium short VIX related products might lead to ‘People Set to get Burned by Volatility‘, as those positions could act as dry kindling ready to burst into a flame of selling should the market start selling off.
Last week Thomas Peterffy, the CEO of InterActive Brokers (IBKR), gave an interview on CNBC in which he provided a new wrinkle to this potentially dangerous market dynamic. Essentially, he described how hedge funds have been the willing buyers of these options, especially on broad ETFs, to engage in short term “gamma scalping”, which has been keeping the market in such a narrow range.
To understand how gamma scalping works let’s look at the phenomenon known as “pinning” during an option expiration.
Often times stocks have a tendency to “pin” to an option strike price on expiration, meaning the stock gravitates to a nearby strike as the close of expiration day trading approaches. This “pin” phenomenon arises from hedging pressures, which can create increased demand for the underlying stock below the strike price and increased supply above the strike, as traders and market makers buy or sell stock to offset expiring option positions.
As the stock rises, the market maker’s portfolio will become more delta positive. What’s the easiest way to remove delta? (What instrument has the highest delta? Stock.) They sell stock. When large sell orders go to the market, what does the stock price do – rise or fall? It falls.
As the stock falls below their target, their portfolio becomes more delta negative. What’s the best way to add delta to your portfolio? Buy stock, which makes the price do what? Rise.
The net result is strikes with large open interest act like a magnet, pulling the stock price as expiration draws nearer.
So how does pinning related to gamma scalping its impact on the market? Gamma is a second derivative and measures of how much your delta will change per unit change in price. It means as prices rise, your delta increases. Or more pertinently, as prices decline your delta turns more negative, meaning you get longer as prices go up, and shorter as prices decline. Here is a pretty graph of the gamma curve.
Getting long gamma provides flexibility and ability to scale in and out of trades as they move in your direction. This is what hedge funds are doing; owning both puts and calls, and as the underlying shares move up they are selling, and as they move down they are buying to return to a delta neutral position.
This activity has let active and high frequency funds a way to make rapid and relatively risk free trades. It also leads to the market getting pinned within a narrow range.
But one needs to remember that magnets can also repel. And when a strong move is under way the options can accentuate or magnify the move. As each strike gets traded through those short (the calls in the case of this rally) need to buy to cover to limit loss. This propels prices to the next level. Suddenly those short calls looking quite worthless just two days or even two hours ago are scrambling to avoid being assigned.
Peterffy says not only will those short options be forced to sell at lower prices, but the hedge funds engaged in gamma scalping may also be at risk, as once their delta has maxed out they will run out of ammunition or the ability to buy dips. They will simply step to the sidelines and wait for the selling to abate.
Peterffy warned this lack of liquidity will create a vacuum, potentially leading to another flash crash.
The market has been in a low volatility and range bound environment for a long time. This has allowed large bets to build, and when it cracks a deluge of selling will follow.