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Hey There Income Hunter,

 

Last year, for the first time in history, option volume surpassed stock volume.

 

In total, buying and selling volumes in option contracts have quadrupled over the past five years according to the CBOE. 

 

I mean who wouldn’t want to buy control of 100 shares of stock by buying a single option contract at a fraction of the cost of the shares? Especially when the Fed was flooding the market with liquidity and traders were receiving free money from the government. 

 

I also think a big part of the growth is that option driven flows, especially during option expiry weeks, have become one of the most important inputs for any stock trader. 

 

Let’s see how …

 

Gamma Time

 

The key to using this information to your advantage is through the analysis of gamma. Gamma is the risk a market maker has to deal with when he chooses to delta hedged his options positions. 

 

By having an educated guess on the impact option expiry may have on outstanding gamma positions you are armed with vital information that can give you a massive edge …

 

Today, I will break down the impact gamma has on delta hedged portfolios and the dramatic effect option expiry can have on these positions. 

 

Gamma Explained

 

When a market maker purchases an option, they are long gamma … If they sell an option, they are short gamma.

 

Let’s run through pricing differences between a stock and an option in order to better explain gamma. 

 

You see, a stock’s price moves based on fundamental changes to its value. An option, however, has multiple inputs to the its pricing model including:

 

• The stock’s price 
• The forward price – Spot (1 + interest rate)T  – dividend distributions
• The amount of time left to the expiration date
• The implied volatility priced into the option

 

The variables, or Greeks, associated with the pricing of an option make it a very dynamic trading vehicle. 

 

So, delta is a variable that predicts the change in an option’s price based on a movement in the underlying security. 

 

Delta values change regularly as the underlying stock’s price fluctuates and gamma is useful because it helps traders see the rate of change of delta and its effect on option values and premiums.

 

When we are dealing with an option that has a strike price the equivalent of the stock price, that option is considered in-the-money …

 

An in-the-money option has a Delta of .50 or 50%. But if the stock moves higher by 1%, the delta moves to 55% and that bump of 5% of delta is its gamma …

 

Here is an illustration for simplicity.

 

 

So, think of the Gamma this way … 

 

Gamma is a second derivative of an option’s price … It measures the rate of change in delta, over time. 

 

If delta is “speed,” then Gamma is “acceleration” for option pricing.

 

Positive and Negative Gamma

 

When you have long option positions, you have positive gamma. When you have short option positions you have negative gamma. 

 

Positive Gamma

 

Positive gamma means that the delta of long calls will become more positive when the stock rises and less positive when the stock falls. 

 

Long gamma also means that the delta of a long put will become more negative if the stock price falls and less negative when the stock price rises

 

Long gamma can be monetized by selling the increase in delta when the stock is trending higher and buying the reduced delta when the stock is trending lower. 

 

So you can see that positive gamma in big size across all trading desks reduces volatility in the market.

 

Why?

 

Because on every uptick in the stock there are sellers of gamma and on every down tick there are buyers of the stock.

 

Negative Gamma

 

Negative gamma means that the delta of long calls will become less positive when the stock rises, and more positive when the stock falls. 

 

Short gamma also means that the delta of a long put will become less negative if the stock price falls, and more negative when the stock price rises

 

Negative gamma adds volatility to the market and it can be quite dramatic.

 

Traders short gamma are adding to the momentum of a trend buy, always buying as the stock trends higher and selling when the stock trends lower. 

 

The Gamma Formula

 

The formula for Gamma is simply the difference in delta divided by the change in underlying price. It can be represented as:

 

Gamma = (D1 – D2) / (P1 – P2)

D1 is the first delta. D2 is the second delta. P1 is the first price of the underlying stock. P2 is the second price of the underlying stock.

For example, suppose stock XYZ was trading at $100 per share and a $100 call option for stock XYZ had a delta of 0.5. Stock XYZ rises to $110 per share and the $100 call option’s delta has risen to 0.7. It is possible to calculate the approximate option Gamma this way:

• Gamma = (0.5 – 0.7) / ($100 – $110)
• Gamma = (-0.2) / (-10)
• Gamma = 0.02

So, the $10 jump in the stock earned you a 2% increase in delta … 

 

How to Use Gamma in your Trading

 

I use SpotGamma as my source of gamma data. Gamma can be displayed as open interest across all strikes of an underlying stock.

 

Every morning I run through the changes from the previous day and reassess support and resistance strikes depending on the amount of positive and negative gamma at each one.

 

Here is an example of yesterday’s set-up going into the day … 

 

 

Notice the 420 strike, it revealed a significant level of open interest in puts associated with real money flows wanting put protection heading into the FOMC meeting on May 4.

 

Now, on the counterpart to the real money buyers are market makers who are short the puts delta hedged with short stock. 

 

This means the short put positions carry negative gamma, so if the market is met with new sellers and SPY gets below 420 … market makers would have to sell stock to rebalance the gamma or they would be getting longer in a down trade and lose money. 

 

The first thing to note is there were size put positions held at 420 so the probability favors real money flows closing their puts after gaining protection from the 5%+ move lower. 

 

Next the market makers buy back their short puts and cover their short stock hedge. This pushes SPY higher and SPY trended up near the 430 strike, which will now be resistance today.

 

So, after a couple of days of SPY trading off about 5% …

 

Bring It Home

 

The tail is now wagging the dog, as they say. Options flows can be a major driver of stock flows due to the amount of trading that must go on purely due to an acceleration in delta fueled by gamma. 

 

There is much more to this story and I will be referring to the gamma flow and how you can use it to get an edge. 

 

Remember there is no more objective way to trade than anticipating the trend based on internal signals from the market itself. 

 

That is what gamma provides, and when the signs line up going into options week you can take advantage of an imbalance and make some easy money.  

 

As always …

 

Live and Trade With Passion My Friend,

Griff

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