Gamma Trap

"Well, gentlemen, the players may have changed but the game remains the same, and the name of that game is 'Let's make a deal.'"
--Jack Trainer (Working Girl)

Interesting article in WSJ (discussion here) seeking to explain why we often get long periods of low volatility punctuated by sharp selloffs. The theory centers around the use of derivative-centered products that investors are purchasing to squeeze out extra income in a yield-starved world, and the hedging that dealers who take the other side of this trade must do.

Over the past several years, conditions of financial repression have found investors reaching for yield in increasingly exotic, and risky, ways. One way is to sell out-of-the-money puts. To sell (or short) a put, an investor borrows the option from a dealer, sells it, and collects the cash proceeds from the sale. As long as the stock does not decline to the point where the strike price is hit on option expiration day, then the investor happily keeps the cash income.

This strategy has exploded in popularity as suggested by the greater than ten fold increase in SPX option activity since 2011.

The dealer who borrows the put for the client to short is now long a put option or its equivalent in stock. Unless the dealer wants to keep a directional bet on its books, then it must go long some stock to hedge.

However, this hedging is not a one-time thing.

A characteristic of options is that someone who is long an option gets longer as the price of the underlying stock approaches the strike price. In options speak, 'gamma,' or the rate of change in the price of the option, goes up as the underlying price approaches the strike. As such, dealers who are counterparties in the above short option trade must continually hedge as stock prices change.

Because dealers are long put options in the trade, an unanticipated decline in stock prices suddenly finds extra gamma on the hedge book that dealers generally don't want. To offset the gain in gamma, dealers buy stock or futures to compensate.

As put selling strategies have increased in popularity (see above chart), the effect on markets is to put a bid under stock prices whenever they suddenly decline, thereby suppressing volatility and, perhaps, lulling investors into a false sense of security.

The graph above indicates the effect. The longer the gamma, the more dealers hedge. The more dealers hedge, the lower the range in daily returns. This is sometimes call 'volatility suppression.'

Seems like nirvana, doesn't it? The more market participants short out-of-the-money puts, the more income they get--with seemingly downside protection provided by their dealer counterparties against price declines.

Sensing as you might that there is no such thing as a free lunch, what could go wrong? One possibility is that dealers could get bearish and keep downside gamma on the books rather than hedge it by purchasing stock, thereby removing the underlying bid in a weak tape.

Another possibility is that stock prices gap down to the point where those who are short puts unwind their trades before they go too far awry. They will be tempted to do so because there are few faster roads to ruin than to be short puts in a declining market. Dealers would then work in reverse, short stock to manage gamma on their hedge books.

Market participants might also unwind their short option trade if interest rates rise and other income-producing opportunities reveal themselves.

Meanwhile, markets are coiling like a spring with increased leverage resulting from large derivative trades. The players may may look different, but we've seen this movie before and it does not end well.

Stability, when facilitated by intervention, leads to instability.