Gamma Effect (Market Gamma) – How it Affects the Market

Investment Banks and Hedge Funds watch Market Gamma very closely as it is highly correlated with movements in the S&P500. It may be the answer to why the market stuck in a range for weeks or suddenly goes crazy. But what is “Market Gamma” and what does it tell us?

# What “Gamma” is

If you traded options before you are probably familiar with “The Greeks”; terms in the options market that are been used when trying to gauge the price movement of an option. Gamma is one of them. While  Delta is how much the option price changes with respect to a change in the underlying asset’s price. The Gamma gives traders a more precise picture of how the option’s delta will change over time as the underlying price changes.

The Gamma decreases, approaching zero, as an option gets deeper in the money and delta approaches one. Gamma also approaches zero the deeper an option gets out of the money. Gamma is at its highest when the price is at the money.

# Why it Affects the Market?

Insurance Companies and Pension Funds increasingly pursue low volatility. Thus, they reach Investment Banks and Brokerage Firms that facilitate those low-vol strategies. These Investment Banks and Brokerage Firms then hedge their side of the transaction by taking the opposite direction. This tends to dampen overall volatility in the market.

# How it Affects the Market?

It has become increasingly apparent that this trading by banks and brokers often goes against the markets, which suppresses the daily movement of stocks and indexes.

Dealer gamma is a dollar value that estimates how much options dealers may have to hedge for a given move in the market.

For example, If we measure gamma for a 1 point move in the S&P500, and the current gamma estimate is +$1bn, so if the market moves from 3001 to 3002, dealers will have to sell $1bn in equities. If the market goes down from 3001 to 3000 the dealers would potentially buy $1bn in equities. If gamma was negative, then the opposite would occur (BUY when the market moves up, SELL when the market moves down).

An Options Gamma Trap is when options dealers are positioned “negative gamma” and cause large swings in the stock market. To hedge a negative gamma position, you sell stocks when the market is dropping and buy stocks when the market is going up. Therefore, any move in the market could be compounded because dealers must hedge in the same direction as the market.

Market Gamma 1

# Summary

The Total Market Gamma is often the metric that most people are familiar with. As previously explained, when the total gamma is positive, the market tends to have smaller price distribution, with a slightly positive average daily return. When gamma is negative the price distribution widens out substantially and things get more volatile. Also, we estimate a negative average daily return.

One-day moves up or down in the stock market are small when gamma is strongly positive, but much larger and more varied when it is negative.

Market Gamma 2- Gamma Effect

Negative Gamma (also ‘Gamma Gravity Trap’) making the market considerably more vulnerable to dramatic downside collapse (and upside meltups) than many believe. In fact, the gamma trap is making it harder to tell whether news or events are properly reflected in market prices.

Based on the above, your trading style should depend on the market gamma levels. We think that markets with high positive gamma tend to be mean-reverting with a tight trading range. Negative gamma markets may feature wide price changes with more of a directional basis.

An example of a typical “high gamma” day:

Market Gamma 3- High Gamma Day

You may want to use the high spikes to sell your longs or buy puts options, or may swing-trading between significant levels.

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