This article is part of a more broad series of research questions I address regarding Gamma Exposure. Check out this post for more.
Market makers are exposed to risks in the market and continuously protect themselves against these risks. One way they they manage risk is by remaining delta neutral on their portfolio. This is called delta hedging.
Say you wish to buy one call option on SPY which has a delta value of 0.45. The market makers, who took your order, will have the opposite position of a -0.45 delta.
When the market maker sells you that call option, they can immediately hedge against their -0.45 delta by buying one call option on SPY with a 0.45 delta OR by buying 45 stocks, (which always have a delta of 1).
For the purposes of gamma exposure, we make the assumption that the market makers are hedging their trades by buying stocks in the underlying instrument.
What is gamma in risk management? How do you hedge gamma?
Gamma is a risk to the market maker when the markets are moving drastically in one direction. Gamma hedging is done to protect the dealer from larger than expected moves in the underlying options contract.
Gamma is the convexity of an options position, and is never get hedged away immediately. By continuously hedging delta risks, dealers hope to limit their exposure to large moves in the stock.
To go along with the example above, let’s assume the dealer gamma has a value of -0.05.
Say your call position moves up $1, and now on the market makers book, they have a delta of -0.50, down from -0.45. The dealer would look to sell 5 more shares of the stock. The gamma was at -0.05 and the underlying price moved up by $1, and this caused the delta on their books became more negative by this -0.05 amount.
If the call position moves down $1, from a delta of -0.45 down to -0.40 on the dealers books, then the dealer would look to buy 5 shares of the stock.
It is this simple (theoretical) illustration that shows the activity of market makers (dealers) that can help you understand the activities of those and how those active rehedging programs can have such a sizable impact on the options and stock market.