Gamma Flows & Dealer Hedging & Nvidia News

CLUB/EDGE client post Tuesday, September 3rd, 2024. Focus on dealers offside in VIX and chasing NVDA short.

» CLUB/EDGE client post SEPTEMBER 3RD, 11:36 PM ET.

Today’s sell-off was brought to you by...

• Ueda of BOJ in the early morning talking up rate hikes on imaginary inflation…

• on top of Oil crashing despite so many geopolitical risks triggering carry trade unwind…

• with the sell-off accelerated following a weak ISM Manufacturing Index…

• all the while Semi sickness impacted dealer hedging.

I spoke of all these dynamics in my live trading room and in my earlier market thoughts post today:

Dealer Hedging & Gamma Flows

I was asked to explain what I meant by “Dealer Hedging” impacting market selling action.

@GammaLab already did it for me:

Price action was a nice example how "gamma flows" can impact the market: Once the underlying drops below the level were option dealers switch from a long- to short-gamma regime, volatility can increase rapidly, as dealers then need to chase the price either lower or higher in order to keep their books delta-hedged.

We recently published a primer on delta-hedging/gamma flows on X, here is a shorter version:

Delta-Hedging: Delta-hedging is a risk management strategy used by option dealers to mitigate directional risk associated with holding opt´ions.

Hedging Mechanism: Option dealers want to be "market neutral," seeking to avoid directional bets, and continuously adjust their positions in the underlying S&P 500 index based on the net delta exposure of their options portfolio. If the delta indicates exposure to an upward move in the S&P 500, they may sell shares or futures contracts to hedge. Conversely, if exposed to a downward move, they may buy shares or futures.

Example:

If a dealer holds a large number of long call options, they will short the underlying futures to hedge against a rise in the index.
If the dealer has an overhang of short put options, they will go short on the underlying asset to hedge against a decline in the S&P 500.
This process requires continuous rebalancing as the market moves, leading to buying and selling pressure in the underlying S&P 500 futures market.

Gamma and Its Influence on Delta-Hedging: While delta measures the sensitivity of the option’s price to the underlying asset, gamma measures the sensitivity of delta itself.

Positive Gamma: When dealers have positive gamma, dealers will need to sell underlying futures into strength and buy into weakness.

Negative Gamma: When dealers have negative gamma, dealers are forced to sell into falling markets and buy into rising markets.

Gamma Flows and Broader Market Influence

Gamma flows can have significant effects on the broader market, especially when large volumes of options are traded and are the largest non-fundamental market force.

• Stabilizing Effects (Positive Gamma): When dealers are in a positive gamma position, they typically buy when prices fall and sell when prices rise. This can have a stabilizing effect on the market by dampening volatility and supporting mean-reversion. In this scenario, dealers' hedging activities act as a buffer against large price swings, reducing market volatility.

• Destabilizing Effects (Negative Gamma): When dealers are in a negative gamma position, they are forced to sell as prices decline and buy as prices increase, which can exacerbate market trends and lead to increased volatility, particularly in fast-moving markets, as their actions add momentum to the price movements. Negative gamma positions can amplify market moves, potentially causing sharp rallies or sell-offs, as dealers chase the market to keep their delta-hedges in line.

• Volatility Events and Gamma "Pinning": Around key options expiration dates, large concentrations of options can create significant gamma effects. For example, if a large number of options are clustered around a certain strike price, dealers' hedging activities can cause the market to "pin" to that level, as their hedging flows dampen any movement away from the strike price. Alternatively, if the market breaks away from a major strike level with significant negative gamma exposure, this can lead to rapid and outsized moves as dealers scramble to adjust their positions.

• Impact on Market Liquidity: Gamma flows have a major impact on market liquidity. When option dealers are forced to hedge large gamma exposures, their actions can either absorb or supply liquidity to the market. During periods of high negative gamma exposure, liquidity can dry up as dealers become aggressive in their hedging, leading to larger price swings and increased volatility. Conversely, in periods of positive gamma exposure, dealers provide liquidity by buying and selling in a way that counters market moves, reducing the likelihood of extreme price movements.

Hope this educational sidebar helps!

Chasing NVDA Short!

As a result of dealer hedging the selling in a negative gamma regime today, we had Nvidia posting its biggest single-day loss of market cap by any stock in history today.

Nvidia's market cap fell $279 billion today, the largest single-day decline for any company in history. That's bigger than the market cap of 474 companies in the S&P 500.

And this was before the 5PM ET headline!

$NVDA GETS DOJ SUBPOENA IN ESCALATING ANTITRUST INVESTIGATION

A reminder from my Trading Room Summary for clients - August 28th:

"it looks like QQQ 465.11 daily gap fill will hit with overshoot to 463.63 hourly gap fill before I can see if market gets defended and marked back up into September OpEx..."

Right idea, but not quite low enough target. Even today in the trading room I gave NVDA short below $115.62 with $110.10 hourly gap fill as high conviction Chase short.

It traded down to $106 after hours.

Reminder: trading is not a game of perfect.