What I’m currently reading in January 2020

As of January 2020, here are the books at the top of my reading list. I’m currently flipping back and forth from these books on various topics.

Trading and Exchanges: Market Microstructure for Practitioners by Larry Harris

I first heard of this book from squeezemetrics on Twitter. This individual said that this was one of the best books they found to gain a deeper understanding of the markets, and helped inspire the gamma exposure research that they have completed.

I got this a month ago and have to agree that this book is fantastic at helping you understand the inner workings of the stock market. If you are up for advanced knowledge on the markets, this book is for you.

From Amazon:

This book is about trading, the people who trade securities and contracts, the marketplaces where they trade, and the rules that govern it.

Readers will learn about investors, brokers, dealers, arbitrageurs, retail traders, day traders, rogue traders, and gamblers; exchanges, boards of trade, dealer networks, ECNs (electronic communications networks), crossing markets, and pink sheets.

Also covered in this text are single price auctions, open outcry auctions, and brokered markets limit orders, market orders, and stop orders.

Finally, the author covers the areas of program trades, block trades, and short trades, price priority, time precedence, public order precedence, and display precedence, insider trading, scalping, and bluffing, and investing, speculating, and gambling.

The Big Book of Dashboards: Visualizing Your Data Using Real-World Business Scenarios by Steve Wexler, Jeffrey Shaffer, and Andy Cotgreave

I got this book because I want to improve my data visualization abilities for this blog and for those charts I post on Twitter as well. I also want to improve my own record keeping process for my trades and create a more professional dashboard that will allow me to review past trades.

From Amazon:

Comprising dozens of examples that address different industries and departments (healthcare, transportation, finance, human resources, marketing, customer service, sports, etc.) and different platforms (print, desktop, tablet, smartphone, and conference room display) The Big Book of Dashboards is the only book that matches great dashboards with real-world business scenarios.

Option Volatility & Pricing: Advanced Trading Strategies and Techniques by Sheldon Natenberg

I’ve had this book for a few months, and I’m constantly coming back to it for a deeper understanding on options and the options market.

This book is great for anyone looking to dive deeper into understanding options and options theory. If you trade options or just want to understand the options market better, this one is a must read.

From Amazon:

One of the most widely read books among active option traders around the world, Option Volatility & Pricing has been completely updated to reflect the most current developments and trends in option products and trading strategies.

Featuring:

Pricing models
Volatility considerations
Basic and advanced trading strategies
Risk management techniques
And more!

Written in a clear, easy-to-understand fashion, Option Volatility & Pricing points out the key concepts essential to successful trading. Drawing on his experience as a professional trader, author Sheldon Natenberg examines both the theory and reality of option trading. He presents the foundations of option theory explaining how this theory can be used to identify and exploit trading opportunities. Option Volatility & Pricing teaches you to use a wide variety of trading strategies and shows you how to select the strategy that best fits your view of market conditions and individual risk tolerance.

Links above are affiliate links. If you purchase any of those books through the link I posted, I’ll get a tiny cut of the sales proceeds. Your support is appreciated.

How the limit order book became abstracted into options and why gamma exposure matters

Information obtained from a thread courtesy of squeezemetrics via Twitter

You know how old-school traders talk about using the limit order book to know where supply and demand are? Basically what happened is that the limit order book got abstracted into options, and the actual buying and selling is now done by option dealers, on behalf of customers.

So what happens is, I sell a call because I want to collect some premium and give up some upside. This is largely equivalent to submitting a bunch of progressively larger limit sell orders above the market, except that those orders cannot be seen.

So what happens is that the option dealer takes the other side of those would-be limit orders by shorting the underlying and committing to, in this case, a schedule of buying the underlying when it goes down, and selling more when it goes up.

This means that there are, through the agency of the option dealer, a bunch of what are effectively limit orders sitting above and below the market, all of which will push against any move in the underlying itself. The more of these there are, the more stifling it gets.

So when GEX is really high, that’s when it’s super-stifling. BUT WAIT THERE’S MORE. As these call options lose value, the dealer slowly buys back some of the underlying that they shorted before, slowly supporting the market, ceteris paribus. Low volatility, upside drift.

(Hopefully it’s obvious why knowing where supply and demand will be is useful.)

What is delta hedging? How does this influence option market makers’ gamma exposure?

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.

Example

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.

Example

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.

Why does gamma exposure suppress or exacerbate stock price movements?

This article is part of a more broad series of research questions I address regarding Gamma Exposure. Check out this post for more.

When gamma exposure is positive, it implies that market makers will hedge their positions in a manner that stifles volatility. It means market makers are selling into highs and buying into lows. They are essentially buying the dip and selling the rip, and keeping volatility low in the process.

When gamma exposure is negative, it implies market makers will hedge their trades in a manner that magnifies the movement of the market. Market makers are now selling into the lows or buying into the highs.

Market makers are buying or selling their stock positions in the same direction with the current market. This is one reason why selloffs can become so deep, and why the swing back after a market selloff is so dramatic.

Much of this has to do with the effect of gamma and how it affects the delta of an options position. The gamma is a measure of the effect a $1 move on the underlying stock will have on delta.

If a market maker has a large gamma exposure value in their option book, then a $1 move in the underlying has a large effect on the delta exposure of a dealers book. This means when gamma is high, you can anticipate large changes in the delta, which the dealer will ultimately hedge against.

What basic assumptions are made in calculating gamma exposure?

This article is part of a more broad series of research questions I address regarding Gamma Exposure. Check out this post for more.

Note below adapted from SqueezeMetrics White Paper

There are a few assumptions we make when we calculate gamma exposure. These are the following assumptions:

All options traded are facilitated by delta-hedgers. We assume that all orders run through a market maker who owns a book of options.

Call options are sold by investors and bought by market makers. Based off skew, open interest at a strike, and effects of GEX, call overwriting drives the options market for calls. We assume call options are written as covered calls for portfolios.

Put options are sold by investors and bought by market makers. Puts are bought by parties looking to protection their portfolios against a drop in market prices.

Based off skew, the implied volatility of put options is generally higher than the implied volatility for call options.

Market makers hedged deltas continuously. This may not be the case, but the assumption is held for the purposes of gamma exposure.

Possible issues for those assumptions above:

If traders and investors are buying more call options than they are selling to market makers, this would drastically change the calculation of gamma exposure. This would also be true if traders and investors are selling more put options than they are buying from market makers.

Like any signal in the market, the gamma exposure signal could go away as it becomes more known. For that reason, gamma exposure should only be used as one component of your decision making process.

Great Resources on Gamma Exposure

This article is part of a more broad series of research questions I address regarding Gamma Exposure. Check out this post for more.

SqueezeMetrics – White Paper on Gamma Exposure

We believe that the greater granularity of the GEX distributions suggests that there is some element of market volatility that is simply not able to be captured by the VIX model, or indeed any other variance metric based on quoted option prices. Rather than prices, GEX concerns itself with the quantity and characteristics of all existing option contracts at all strikes, and at all expirations―and the market participants who trade them.

Conclusion

If investors continue to look toward the option market for alpha signals and risk assessments, they would do well to consider Gamma Exposure as a smarter alternative to price-derived volatility and variance estimates.

The key deficiency in using option prices to gauge future volatility is that no two market-makers’ books are the same, and a tight spread from any one market-maker completely obscures the risk appetite of every other.

This problem is readily ameliorated by computing the GEX of options known to be in circulation and deriving projected return distributions from the historical market impact of those contracts.

And so, when―in light of the evidence―investors eventually acknowledge that the option market does have a truly pervasive, day-to-day impact on the paths and volatilities of stock prices, we think that it is a natural next step to consider GEX an essential addition to the equity investment process.

SqueezeMetrics – Documentation

Gamma exposure (GEX); refers to the sensitivity of existing option contracts to changes in the underlying price. Like with DPI, substantial imbalances can occur between market-makers’ call- and put-option exposures, and when those imbalances occur, the effect of their hedges can either accelerate price swings (like a squeeze) or stifle movement entirely.

We have developed a novel way to quantify this exposure and the direction of hedging that occurs in the event of n% price moves. The effect of this insight on our forecasting has been profound.

SqueezeMetrics – Monitor

This monitor by SqueezeMetrics will provide you with Dark Pool buying as well as Gamma Exposure for all of the components of the S&P 500. (Please note, this is NOT Gamma Exposure on the S&P 500 index (SPX) itself. Rather it is a calculation of all of the component stocks on the S&P 500. For SPX GEX, you can subscribe to SqueezeMetrics or find that information at TradingVolatility below.)

Trading Volatility – GEX Charts

Gamma Exposure Charts

A view of the cumulative Gamma Exposure (in $) across each strike for a given stock, calculated using all options with less than 94 days to expiration.

Spot Gamma – Updated Tables on Gamma by Strike and by Expiration Date

These options data tables based on open interest produce gamma readings which can be used to define important levels in the S&P500 (SPX) market. This data is recalculated each night based on a proprietary model. Some traders and investors believe that large open interest at a specific options strike produces actionable trading intelligence. These tables are all grouped by strike, not expiration date.

Bookmark this post if you wish. I will be updating it frequently. Consider all my posts to be a work in progress.

If you have other resources with regards to Gamma Exposure, please share them in the comments below!

Understanding Gamma Exposure and How it Moves Markets

In this series of articles, I will address a concept known as gamma exposure.

Gamma Exposure: A very brief overview

Gamma exposure is an estimated measure of the overall option market makers’ (aka option dealers’) exposure to the options Greek known as gamma.

Gamma exposure is an estimate that can help you gauge future volatility and stock price variance.

Gamma exposure informs you how options market makers will likely need to hedge their trades to ensure their options books are balanced.

Much of the discussion on gamma exposure relates to options traded on S&P 500 (SPX) because the options market on this ticker has outsize effect on determining the index price level.

My introduction to Gamma Exposure

I first heard about gamma and its effect on stocks from notes written by Charlie McElligott at Nomura.

I’d see articles from time to time and gamma exposure seemed rational and interesting. I just had to learn more.

I discovered SqueezeMetrics on Twitter which provided me with more information regarding gamma exposure than any other source I’ve seen yet.

Go check out SqueezeMetrics and white paper to learn more. It was one thing I found that actually seemed to explain why the market moved the way it did over very short term (1-3 day) time periods.