Derivatives Series – Understanding Gamma Flip - Part 1

Derivatives Series – Understanding Gamma Flip - Part 1

Chapter 1: Introduction

To understand Gamma Exposure (GEX) and the Gamma Flip, you have to stop looking at the stock market as a collection of investors guessing which way a stock will go. Instead, you must look at it as a giant machine managed by Market Makers.

Market makers are the "plumbing" of the financial system. When you buy or sell a call option on Robinhood or E-Trade or ICICI-Direct or any other trading platform, you aren't usually buying from or selling it to another retail trader; you are buying it from a massive institution like Susquehanna or ICICI Securities. These institutions do not want to bet on whether the market goes up or down. They want to remain "delta neutral"—meaning they want to collect a small fee (the spread) while ensuring that a $10 move in the S&P 500 doesn't gain or lose them a single penny or Rupees.

The Gamma Flip is the "mechanical" trigger point that determines whether these market makers are forced to stabilize the market or accidentally set it on fire.

Chapter 2- The Building Blocks (Delta and Gamma)

Before we can understand the "Flip," we must understand the "Optons Greek" relationship that causes it.

1. Delta: The Speedometer

Delta measures how much an option's price changes for every $1 move in the underlying stock. If an option has a delta of 0.50, and the stock moves up $1, the option price moves up $0.50.

To stay neutral, if a market maker sells you a call option with a 0.50 delta, they are "short 50 deltas." To offset this, they must buy 50 shares of the actual stock. Now, if the stock goes up, their loss on the option is perfectly cancelled out by their gain on the shares.

Delta is also the hedge ratio, i.e. if a market maker sells you a call option of 1000 shares of common stock with delta of 0.6 means that the call writer is “short 60 deltas”, i.e. for each $100 increase in the value of the underlying stock, the call option will increase by $60, to offset this, the call writer will require to simultaneously purchase 600 shares of the underlying stock to hedge his position against his risk of the possible exercise of the option, which means, if the stock goes up, the call writers loss on the option is perfectly cancelled out by their gain on the shares The combined position is Delta Neutral and this process is known as delta hedging.

2. Gamma: The Accelerator

Gamma is the rate at which Delta changes. Delta is not a fixed number; it moves as the underlying stock price moves.

In the money call options will tend to have a delta of +1 (-1 for Put) and the option behaves the same as the underlying.  At the money call option delta tend to be around 0.5 (-0.5 for put). Out of the money call options or Put options have a delta heading towards Zero

This creates a problem for the market maker. Their "perfect hedge" of going long on 600 shares mentioned earlier only works for a split second. As the stock price moves, their delta changes, and they are forced to buy or sell more shares to keep their hedge "neutral." This constant re-hedging is what drives the Gamma Flip phenomenon.

Chapter 3: What is Gamma Exposure (GEX)?

Gamma Exposure (GEX) is a calculation of the total dollar amount of hedging that market makers must perform for every 1% move in the underlying stock.

When you aggregate every single option contract currently open in the market (the "Open Interest"), you can see the "net" position of the market makers. Because market makers are usually the ones selling options to the public, their exposure is the inverse of the public’s positioning.

To understand Gamma Exposure, we need to understand the phenomenon of “Short Gamma” and “Long Gamma”

If a market maker sells a call to the retailer, the market maker is "Short Gamma." And if a market maker buys a call from the retailer, the market maker is "Long Gamma." Let’s explain in details:

Negative Gamma (Short Gamma)

Negative Gamma occurs when market makers are "short" options, typically because they have sold puts to investors seeking protection or calls to speculators. 

• Hedging Behavior: Market makers must stay delta neutral by selling the underlying asset as the price falls and buying as the price rises.

• Market Impact: This "sell low, buy high" activity amplifies volatility and can lead to explosive price swings, as they trade in the same direction as the market move (gamma squeeze).

• Risk: This is a high-risk environment for market makers because their losses on the short options accelerate as the underlying moves further against them

Positive Gamma (Long Gamma)

Positive Gamma occurs when market makers are "long" options, meaning they have bought more options from the market than they have sold. 

• Hedging Behaviour: To stay delta neutral, the Market makers must do exactly the opposite, i.e. hedge by buying the underlying asset when the price falls and selling when the price rises. This "buy low, sell high" activity acts as a volatility dampener.

• Risk: This is a low-risk environment for market makers, because it creates a stabilizing effect, often leading to range-bound markets or "pinning" a stock's price near high-volume strikes.

• Profitability: Market makers can "gamma scalp" in this environment, making small profits by trading against the market's direction to maintain their hedge. 

In part 3, we shall discuss what is Gama Flip and why does it matter