What's A 'Gamma Flip' (And Why Should You Care) | Zero Hedge 19/12/2019, 18:45

What's A 'Gamma Flip' (And

Why Should You Care)
Authored by Thorsten Wegener via MacroHive.com,

There is a new buzzword in town: ‘Gamma Flip’. It is used to explain

(due to a lack of any sane explanation for current market
behaviour) why the S&P seems stuck at practically all-time highs
and what might happen if things turn bad. In fact, it is so hot that
even TV pundits are elaborating on its potential advantages and dangers.
But what exactly is it?

Learning Greek

Gamma as a thing has been around since traders began to use options to
hedge, speculate, and mitigate risk. But it was not until the shiny Black-
Scholes model emerged in the ‘70s that anyone knew what to call it.
Bluntly, gamma is the first derivative of the option delta and describes the
sensitivity of the delta in relation to price movements of the underlying
security. A flip is the transition from a prior (in this case positive) state, to
its opposite (now negative) state. For many that’s hardly an eloquent
answer, nor even a particularly explanatory one. Of course, there is a
far easier way of describing gamma (and the potential flip it
implies), but to reveal it would rob derivatives experts of their
inordinately rotund paycheques… Luckily for you, nobody is paying
me to be pretentious anymore.

Selling Options

The majority of investors own equities. Only a few short them to make a
living. Pension funds, asset managers, or family offices sit on large equity
holdings producing (apart from anxiety) dividends. And that’s pretty much

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it. But there is a way to squeeze some additional returns out of your
existing positions: namely, selling call options above the current market
level. The logic, especially after a long bull market, goes as follows.

Let’s say you are sitting on rather good performance figures by holding a
market portfolio. The market went up for a long time. That’s awesome.
However, you think the air is getting thinner up there and expect a market
correction is around the corner. Maybe there is room for another 10%, but
that’s it. So, you think to yourself, ‘why don’t I start selling my holdings
potentially 10% above the current level?’ To achieve this, you can sell call
options at levels above the current market to some unfortunate market
maker (dealer) at a big financial institution. If the market does rise another
10%, you will fully participate up to that point and will have generated
additional income through the option premium received for selling to the
friendly market maker the privilege of participating on the spoils above the
unlikely up move.

To add insult to injury, you will ask the poor sap at the same time for a
price to protect your portfolio against a market drop and buy some ‘crash
protection’ (e.g., put options). That will show him. With a lot of supply on
the upside and increasing demand on the downside, prices for calls will fall
and prices for puts will increase. This is what is called an investment skew
and you can observe it in every equity options market and sometimes also
in a commodities market (this tells you some very interesting things about
market conditions but is a story for another column).

So far, so good. You have sold some potential upside performance against a
fee and hedged yourself against some downside risk. You are still
interested in a positive market development and want to be long overall.

The Advantages of Being Long

However, the market maker does not share your inclination. He wants to

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be market neutral; he is not payed to take any directional risks and abhors
the idea of predicting anything other than volatility (I should know, I used
to be one of them).

Now when you own options, you are ‘gamma long’. Gamma long is
pretty cool, especially for market makers. When markets move, a long
gamma will always work in your favour no matter whether you own calls or
puts or both. If markets are rising, you suddenly become long. If markets
decline, you are suddenly short (well, not really suddenly – you can
actually calculate by how much, but for argument’s sake let’s say that is
what happens). Unfortunately, you will have to pay for that privilege by
losing gradually the stored time value in your option position, the so called
‘theta’.

The good news is you can actually earn it back if markets move.
If you are long call options at let’s say 3150 points in the S&P (i.e., the level
of the S&P as of writing), every further move to the upside increases your
long position and your theoretical profit. To lock this profit in you sell on
up moves and you buy on down moves, adjusting your market maker book
back to neutral. If there are a lot of market makers around who have been
forced to bid for call options, this is exactly what they are doing. All of
them, all the time.

Suddenly this level become very sticky. Every bit of volatility is

being used to recover the lost time value of the options that the
market makers are now sitting on. And as these positions slowly
waste away, the urge to compensate for this by hedging with every little
move becomes stronger, slowly bringing the market to a standstill.

Due to the nature of gamma, these points are largest where the
most options have been sold and bought. And they are easily
trackable with a quick check of the open interest. The further the market
moves away from these inflection points the less gamma is in the market,
decreasing the urge to hedge all the time. It’s like wading through a
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swamp; once the market clears it, things start happening again.

Watch the Market Makers

So why do markets move at all if gamma is, like in this example, the big
decelerator? Because it depends who owns it. Market makers use their
gamma because they must. There is nothing worse than sitting on a
position and bleeding white over time as your options deteriorate.
Institutions, on the other hand, do not have to get panicky as they benefit
on their sold upside positions over time and use their long, protective
position to the downside to insure their portfolio. If they were to do the
same as the market makers – trade in and out of positions to utilize their
long gamma – they would become neutral, which is clearly not what they
wanted by setting up this position in the first place. So, the market
downside is now defined by institutions who do not use their long gamma,
which would make the market sticky but by market makers who are
gamma short.

You remember what I said about long gamma being cool? Well
short gamma is terror. If the market moves against you, you will
always have to do what you do not want to: shift your positions to neutral.
In a falling market you are suddenly long; in a rising market you
are short.

We have already covered the long side of the market and deduced that
things get a bit sticky there because market makers have to sell when
markets rise and buy when markets fall. The opposite is now true on the
downside. With markets gathering speed towards one of the lower
inflection points, the same market makers who had long gamma on the
upside now have to compensate for their short gamma positions, which
actually means they have to sell when markets are low, sell a bit more
when they get lower, and sell a shitload when the market tanks. What used
to facilitate a sticky market on the top is now cause for a

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very slippery market on the bottom.

The Flip

The expression ‘gamma flip’ simply describes the point where

long gamma positions of those who use them turn into short
gamma positions for those who actually would have a need to
use them, but don’t have them. In other words, it’s the point in the
market where you want to step back and graciously wait until the forces of
good and evil have battled it out and more sane explanations like macro
factors, corporate earnings, or illusive trade deals make the headlines
again. That’s it. That’s the simple explanation.

What I haven’t told you is that gamma also reacts in mysterious

ways in relation to time, volatility, and distance to spot markets.
But that must wait for another column. In the meantime, the gamma flip is
supposed to happen at levels of roughly 3070 points in the S&P. Of course,
it might just slowly fade away while we see new highs. If you read this
column at some future date, we will know what has happened.

* * *

Thorsten Roland Wegener spent twenty years trading equity derivatives

and was a partner at Bear Stearns. Currently, he teaches as well as
cooking, driving, and cleaning lots.

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