Why do options market makers take on short volatility positions?

Adapted from Options Volatility and Pricing Textbook by Sheldon Natenberg.

Option market makers typically profit when there is more options volume being traded. The reason for this is market makers profit from the difference in the bid-ask spread, and higher volume provides and opportunity for them to take in more profits on this spread.

When options trading volume is elevated, you also tend to see higher volatility in the market. This is because demand for options increases as volatility increases due to market participants purchasing protection for their portfolios and/or speculators looking to profit from large price swings.

Market makers have an indirect long volatility position

As a result of this, option market makers have what is known as an indirect long volatility position, because they profit when volatility is high as a result of increased volume. Market makers want an increase in the volume of options but not because they have long volatility positions per se.

To hedge against this indirect long volatility position, you will see market makers take short volatility positions in volatility contracts, most commonly the VIX.

The market maker takes a short volatility position because they want to hedge themselves against the possibility of there being low trading volume which would ultimately hurt their profits.

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 an options market maker (options dealer)?

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

An options market maker is an individual (or more likely institution) that has a contractual relationship with an exchange, like the CBOE (Chicago Board Options Exchange) to ensure there is liquidity in the options market.

When you trade options, the person on the other side of your trade is generally going to be a market maker. They are the people who make it so that you can more easily buy or sell an option contract at some strike on some expiration date.

Market makers ensure that transactions are completed quickly in the options market even where there doesn’t seem to be a buyer or a seller. Transactions would be harder to conduct, and options trading may not be as commonplace.

What is the motive of the options market maker? How do they make money?

Market makers can make profits on almost every trade. The way that they can do this is by buying the offer and selling the bid, and maintaining what’s called a bid-ask spread.

Market makers benefit from spread between the bid and the ask since they are the buyer or seller when they need to be.

For this reason, once market makers build up a large book of options, they must continuously monitor their portfolios and hedge against risks that could make them end up losing money in the long run. This ultimately has a huge impact on the S&P 500 index.

This is why the Greeks are so important to market makers and can help them protect themselves by hedging theirs portfolio of options against those different risks.

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.

Want to Gain a Deeper Understanding of Gamma Exposure?

Frequently Asked Questions

What are the options Greeks?

What is gamma in options trading?

What is an options market maker (options dealer)?

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

Why does gamma exposure suppress or exacerbate stock price movements?

What basic assumptions are made in calculating Gamma Exposure?

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

Learn more about Gamma Exposure with these great resources

Risk management is more important than predicting the future

Everyone wants to predict the future. It’s fun to speculate and guess what will happen next in the market. So everyone tries to do it.

This can be a fruitless effort though.

See, the problem with making predictions is your ego. You want to be right so bad. For many beginners and experts too, the position themselves too much based off overconfidence in their predictions.

I was overconfident in October that we would see a market drop. I strongly believed that there were a multitude of factors that would bring the market down.

We had no real China trade deal.

Even so, earnings were going to be down year over year.

Even so, the Fed was going to cut rates, and after they cut multiple times earlier in the year the markets sold off.

Even so, the economic numbers didn’t look good.

Even so, the repo markets were out of control to the point the Federal Reserve felt the need to intervene.

The market just had to go down, right?

Well, I was wrong and lost too much money as a result.

No matter how right you think you are, there is a good chance you can still be wrong. It may not make any sense. None of this rally over the past six weeks made sense to me. But it happened, and I didn’t manage risk properly and I suffered the consequences.

Lots of Gamma Exposure keeps the market afloat

gex tv 12119

Source

What is gamma exposure?

Source: TradingVolatility.com

There has been recent research published into the concept of “Gamma Exposure” (“GEX”) on the book of options Market Makers.

In summary:
– Market Makers provide a market for people to buy and sell options.
– Market Makers don’t just take the opposite side of the trade that investors take. They hedge their exposure so that they can profitably manage an options book.
– The hedges must be re-hedged daily so that their position can remain neutral as the underlying stock prices move.
– In scenarios where “Gamma Exposure” gets off balance to the negative side, Market Makers must sell as prices drop and buy as prices rise, accentuating the movement in stocks. Oversold conditions result in a setup for a short squeeze, where both investors are buying oversold conditions AND Market Markets are re-hedging their positions by buying as the stock price rises. The result is a pop higher in the stock.

Source: SqueezeMetrics

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.

I will post more on this topic to come in the future. Please subscribe to be updated when I post this.

How to download S&P 500 data from Yahoo Finance using Python

Make sure you have the yfinance package installed first. If you don’t, you can run the following command in your Jupyter notebook:

!pip install yfinance

Input:

import pandas as pd
import numpy as np
import yfinance as yf

Input:

spy_ohlc_df = yf.download('SPY', start='1993-02-01', end='2019-12-01')

Output:

[*********************100%***********************]  1 of 1 downloaded

Input:

spy_ohlc_df.head()

Output:

Conclusion

This is a very brief summary of how you can download stock data information for the S&P 500 from Yahoo Finance, using the Python programming language. If there is something you want to learn about, please let me know in the comments below and I can cover it in a future blog post.

It’s not if, but rather when will a market pullback happen

We’ve had an extremely long run up in the market over the past month and a half.

The S&P 500 is up 8.8% since October 8. The market has barely had much of a pullback since this rally started. It feels like the market won’t pullback at any point soon. But it will happen.

There are a lot of questions to think about though when it comes to timing a pullback in prices:

How much long will markets run higher before the market pulls back?
What will the depth of the pullback be when it does happen?
What is the likely magnitude of the pullback?

These are all impossible to know, but are at least worth considering.

My prediction is that we experience a pullback sometime after December 20, 2019. Why that date? It’s the infamous quad witching date. What’s that?

What Is Quadruple Witching?

Quadruple witching refers to a date on which stock index futures, stock index options, stock options, and single stock futures expire simultaneously. While stock options contracts and index options expire on the third Friday of every month, all four asset classes expire simultaneously on the third Friday of March, June, September, and December.

Source

There is large gamma exposure coming off the books on this date. To the order of $2.7 billion. Source

There are the potential risks that could be a tipping point as well. If any catalysts materialize, a pullback is likely.

Possible risks include:

No trade deal with China, or worse, a more tense U.S.-China relationship.
Issues in the short-term funding market where the Fed can no longer control short-term interest rates
Bad guidance on future earnings
Declining GDP becoming more known

I believe a pullback could see much of gains up to this point being wiped out. $2900 isn’t out of the question of being tested at some point in mid-December to mid-January. That’d be down 7.7% from where we are currently at.

A deeper decline is possible, but would need to be closer before any thoughts about it happening.

I think a pullback could be very quick, 3-4 days like August and May pullbacks. Some even say it could be like February 2018 pullback, but I’m not so sure that the magnitude would reach that level.

With that being said, my predictions are usually wrong. Follow Murphy’s Law: Whatever can go wrong will go wrong. So make sure you hedge your bets and spread them out intelligently over some specified time frame.

BREAKING: Trump signs Hong Kong Bill

bbg hong kong

Donald Trump signed a bill into law that expresses U.S. support for Hong Kong protesters, a move that could strain relations with China and further complicate the president’s effort to come to a phase one trade deal.

Will the market react?

I would guess not. Gamma exposure right now is massive. This has held the markets higher for the past month, along with Fed interventions. If these are actually those items holding the market higher for the time being, we will see the current bull trend continue. This is where my bias is with about 65% probability.