Sergei Perfiliev 🇺🇦 Profile picture
Jan 13, 2022 37 tweets 8 min read Read on X
TO ALL EQUITY PMs:

YOU MAY NOT BE INTERESTED IN OPTIONS, BUT OPTIONS ARE INTERESTED IN YOU!

$SPX options make up 16% of the $SPX market cap!

Options gamma is one of the most significant structural flows within the equity markets.

Let's explore how it impacts your business 👇 Image
Options are often linked to insurance.

And many times, rightfully so.

They can help protect your portfolio when the sky is grey, and the rain washes down your hard-earned gains.

However, there's a key and vital difference.
Traditional insurance business typically uses diversification as a risk-management tool.

The exposure to any single adverse event can be hedged by insuring other adverse events that fail to materialize.

With enough uncorrelated bets, it's possible to achieve a positive return.
However, diversification isn't practical when hedging a book of $SPX options.

The primary risk-management technique is delta-hedging, which is when option traders start messing about in the equity markets.

And they are brutal.
They enter like a bull in a china shop, with complete disregard of price and value.

They have no respect for your market.

No appreciation of fundamentals.

No awareness of sector rotation.

No understanding of valuation multiples.
And on top of that - complete ignorance of the available liquidity!

They come.

They take what they need.

And they leave.
Frequently leaving the market perplexed and confused as to what just happened.

Investors are often left with no other choice but to come up with narratives that justify the aftermath of this inconsiderate behaviour.
But that's enough!

I say, no more!

It's time to...

Well, there isn't much we can do apart from trying to understand how and when these options traders impact the equity markets.

At least that way, we'll recognize when it happens, and we'll be prepared.

Ready?
First of all, I assure you that options market makers don't do that just to fuck with you - they have a good and solid reason to trade in your equity market.

In fact, they have no other choice. Image
They do their best to flatten the risk with other options, but the residual exposure is hedged with underlying shares or futures - a process known as delta hedging.

As the underlying moves, so does the delta-hedging requirement.
Market makers are forced to trade the underlying simply due to the price of that asset changing and not for any other fundamental or economic reasons.

This creates a feedback loop, where the type and amount of options that investors trade influences the underlying price action.
It would be equivalent if the act of buying fire insurance impacted the probability of a house burning down.

The amount of delta-hedging needed is mainly dependent on this thing called gamma.

And that's where the fun begins.
Gamma shows the potential amount of delta-hedging activity by the market makers.

It's a source of one of the most significant structural flows in the equity markets.

These flows are non-discretionary (dealers have to hedge) and occur regardless of the available liquidity!
The importance of gamma increased over the last few years as the options market continued to grow and became a sizeable chunk of the underlying equity market.

At the moment, the $SPX options alone account for about 16% of the $SPX market cap.
The total gross gamma outstanding is $8 billion, meaning that market makers need to trade approximately $8 billion worth of $SPX for a 1% move in the index.

Due to its nature, gamma can exacerbate market moves ("short gamma") or dampen them ("long gamma").
And this largely depends on how "the street" is positioned.

(The street == options market makers and dealers == who @jam_croissant collectively calls Gary 🦍)

A quick rule of thumb - you are long gamma when you buy options and short gamma when you sell.
When the street is long gamma, that means option market makers net-net bought options.

Their delta-hedging activity forces them to "buy low, sell high".

They are sellers when the market rallies and buyers when it drops, conveniently adding liquidity and reducing volatility. Image
When the street is short gamma, the opposite happens.

Dealers' book is short options, and they "buy high, sell low".

This exacerbates market moves and removes liquidity (frequently, when it's needed the most). Image
So how is the street positioned?

Finding out net gamma positioning isn't a trivial task as it involves figuring out the direction of options trades.

However, an educated guess can help us approximate gamma exposure.
On an index level, it is generally believed that investors predominantly buy puts for protection and sell calls as part of overwriting strategies.

This is evident in the $SPX skew, which shows higher implied volatility for puts than calls. Image
However, this can overestimate gamma as investors also sell puts for yield (structured products) and buy calls for leverage.

Still, under this assumption, puts carry negative gamma (not because they're puts, but because the street is short them), and calls carry positive gamma.
Hence the street is short gamma on the downside and long gamma on the upside.

A closely monitored data point is where the gamma is zero - known as the gamma flip.

At the moment, this is around 4,660 for $SPX. Image
If we're above the gamma flip, the volatility tends to be low, as the market has to swim against the current of the options flow.

But should the market drop into negative gamma territory, expect fireworks.
In this scenario, delta-hedging flows move in the same direction as the market, potentially amplifying the price action.

As volatility rises, systematic/managed volatility funds tend to cut exposure, further adding to the selling pressure and provoking more negative gamma flows.
Of course, gamma is just one of the market forces here, and its impact largely depends on several factors, such as:

• Time to Expiry
• Open Interest
• Market Liquidity
• Volatility
For any single option, gamma is a bell-shaped curve centered around the strike.

And it's the highest for short-dated, at-the-money (ATM) options: Image
Hence, if the market is trading around a soon-to-expire strike with a high open interest, it's more likely that its gamma flows will impact the market.

The most open interest is frequently concentrated around large expiries and nice, round strikes: Image
What do I mean by "large" expiries?

There is an $SPX options expiration every Mon, Wed and Fri, and traditional monthly options expire every third Friday of the month.

However, longer maturities tend to be listed on a quarterly (Mar/Jun/Sep/Dec) and yearly (Dec) basis only.
For example, currently, only December expiries are listed beyond June 2023.

Since these maturities have been around for longer, they accumulate a considerable open interest.

Quarterly third Friday options also have an added benefit of $SPX futures expiring on the same date.
Delta-hedging and unwinding these positions can increase market activity around the expiration time.

However, are these flows strong enough to move the market?

Well, that depends on the available liquidity at the time.
The higher the liquidity, the more likely the market will simply absorb any delta-hedging flows without even noticing it.

However, at times of low liquidity, gamma flows can be responsible for significant price action around options expirations.
Is there anything that can stop gamma and its evil plans?

Yes, gamma tends to lose its powers in a high vol environment, as delta becomes less sensitive to underlying moves.

This is because short-dated options behave as longer-dated in a high vol environment.
Their gamma isn't concentrated around the strike but is spread around a broader range of underlying prices.

When this happens, it becomes essential to look at delta changes with respect to volatility instead, which we'll explore in our future threads.
Thank you so much for taking the time to read this!

I sincerely hope you found it interesting and valuable.

Follow me (@perfiliev) for more educational threads around stocks, options and other topics within the incredible world of financial markets.
In case you enjoy watching videos, I'd like to invite you to my YouTube channel, where I also cover various financial topics:
youtube.com/c/PerfilievFin…
TL;DR:
• Gamma can exacerbate market moves ("short gamma") or dampen them ("long gamma").
• For $SPX, the street is short gamma on the downside and long gamma on the upside.
• Gamma exposure depends on time to expiry, OI, liquidity and volatility.
• Gamma flip is a price point where gamma is zero.
• Gamma is usually concentrated around round strikes and big expiries (Mar/Jun/Sep/Dec)

In the next thread:

We'll talk about how to quantify and calculate Gamma exposure using simple tools that you can find around the house.

• • •

Missing some Tweet in this thread? You can try to force a refresh
 

Keep Current with Sergei Perfiliev 🇺🇦

Sergei Perfiliev 🇺🇦 Profile picture

Stay in touch and get notified when new unrolls are available from this author!

Read all threads

This Thread may be Removed Anytime!

PDF

Twitter may remove this content at anytime! Save it as PDF for later use!

Try unrolling a thread yourself!

how to unroll video
  1. Follow @ThreadReaderApp to mention us!

  2. From a Twitter thread mention us with a keyword "unroll"
@threadreaderapp unroll

Practice here first or read more on our help page!

More from @perfiliev

Dec 20, 2023
A short preview for my upcoming course 🔥

It's a self-paced online course that explores how financial markets work through stories, examples, charts and infographics, giving you enough context to make sure "it clicks."

Quick thread on what's inside each module 🧵👇 Image
The Financial Industry

• The difference between capital and financial markets.
• What does it mean, when someone works in DCM?
• Shareholders want to get diluted?
• The eternal battle: buy side vs sell side.
• You know what market makes do!
• But wtf investment banks do?Image
Fixed Income Markets

• Why nobody likes fixed income?
• What's a trillion dollars between good mates, right?
• The three sweetest words in financial markets.
• The problem of storing a billion dollars.
• Six mind-blowing facts about yields.
• The secrets of the yield curveImage
Read 10 tweets
Apr 5, 2023
Banking problem is not due to the spread between deposit accounts and money market funds, even though it's historically high.

Nor is it due to deposits running from banks into MMFs.

The issue is that funds leave the banking system because of what MMFs do with that capital.

1/ Image
WSJ reports that more than 40% of MMF assets are invested into Fed's reverse repo facility (RRP).

If capital ends with the Fed, it is dead - it has left the economy and the banking system.

Unlike a typical commercial bank, the Fed doesn't need to invest to offer a 4% return

2/
If RRP wasn't available, MMF wouldn't have a risk-free alternative to invest.

Withdrawn deposits would be invested in a range of money market products and T-Bills - in both cases eventually ending up as deposits at banks.

Instead the money is wired to Fed, where it stays.

3/
Read 4 tweets
Mar 30, 2023
The world runs on dollars.

It's not going away anytime soon - it's too ingrained into the world economy.

9 quick reasons for why it's difficult to replace the dollar despite what the FinTwit is telling you

🧵👇
#1 - In dollar we trust:

In fiat currency system, it's all about trust.

Trust that your currency has value.

Trust that it will be widely accepted.

Trust that the government will do the right thing to prevent the loss of value.
It took time for the dollar to earn it.

And it will take time for any other currency that wants to replace dollar to earn it too.

US dollar is backed up by powerful institutions, like the Federal Reserve, which work to ensure that trust is not compromised.
Read 12 tweets
Mar 25, 2023
Bank: Hey! Fed, help us!!!

Fed: Yo, what's up?

Bank: We need some cash, quick!

Fed: Hey, calm the fck down... What's the problem?
Bank: You told us in 2021 rates will be zero until like forever! So we loaded up on some crap mortgage bonds that pay peanuts.

Fed: Lol!

Bank: Don't fcking lol us! You hiked rates by 5% - all of our bond portfolio is deep underwater. Nobody wants that crap paying 1%!
Fed: So what?! Don't stress out! They'll payout... eventually. You even booked them as Held-To-Maturity bonds, just sit tight, you'll be fine...
Read 17 tweets
Mar 23, 2023
Right now, the spread between the Fed funds rate vs 2-year Treasury yield is the highest since 2008.

What does it mean?

Usually, when the 2-year rate falls below Fed funds, it's an indication that the Fed will cut rates soon.

To see why, think about this 👇 Image
Say you want to invest over the next two years. What would you choose?

1. Invest in a 2-year bond and get paid 3.9% p.a.

2. Invest into a daily Fed funds rate (5% atm) and roll the investment every day at whatever the Fed funds rate is at the time.
If you thought the Fed will raise interest rates such that an average Fed funds rate over the next 2 years would be >3.9%, then it's more attractive to invest with the Fed.

As rates go up, you'll be able to reinvest daily at a higher rate.
Read 6 tweets
Mar 22, 2023
Funny how before 2008, currency in circulation was the Fed's biggest liability.

There was no TGA at the Fed, no RRP facility and reserves were little and paid no interest.

Simpler times.
Following 2008, the Fed changed how it conducted monetary policy - it started paying interest on reserves and later launched reverse repo operations.

In a zero-rate environment, neither of these were expensive to service.
But now, not only has the Fed accumulated $3T of reserves and $2T of RRP, but it's also required to pay almost 5% of interest on them.

While the Fed is not a traditional back and can continue operating at a loss, it did make the system much more dependent on itself.
Read 5 tweets

Did Thread Reader help you today?

Support us! We are indie developers!


This site is made by just two indie developers on a laptop doing marketing, support and development! Read more about the story.

Become a Premium Member ($3/month or $30/year) and get exclusive features!

Become Premium

Don't want to be a Premium member but still want to support us?

Make a small donation by buying us coffee ($5) or help with server cost ($10)

Donate via Paypal

Or Donate anonymously using crypto!

Ethereum

0xfe58350B80634f60Fa6Dc149a72b4DFbc17D341E copy

Bitcoin

3ATGMxNzCUFzxpMCHL5sWSt4DVtS8UqXpi copy

Thank you for your support!

Follow Us!

:(