Gamma is often misinterpreted in the world of equity markets. Let's simplify this concept today.
Understanding Market Maker Gamma
Market Makers (MMs) are intermediaries who facilitate the buying and selling of calls and puts for investors. Their primary goal isn't to speculate on market direction but to ensure liquidity by maintaining a neutral stance on their positions. If they sell call options, they essentially have a short position. To counterbalance this, they'll purchase a corresponding amount of the underlying stock.
However, the challenge arises when the option values fluctuate. They'll need to continually adjust their stock holdings to maintain neutrality.
Why Should You Care?
With trading platforms making options accessible to everyday traders, the options market has expanded exponentially. The Average Daily Volume of option contracts traded has seen over a 100% surge in the past two years.
This magnified options trading activity has a significant ripple effect on stock movements.
For instance, if a surge in call options occurs at particular strike prices, MMs may have to purchase more of the stock as its price goes up, aiming for neutrality. This can trigger a positive feedback loop, pushing stock prices even higher until the effect of gamma diminishes. Notable cases from 2021 include stocks like $TSLA, $AMC, $CLOV, and $GME.
Conversely, when the Gamma Exposure is positive, MMs may sell as stock prices go up and buy as they decrease.
The Key Measurement for Gamma Exposure
Gamma Exposure (GEX) only has an impact when it is significant relative to the number of shares traded in a given stock.
GEX provides a measurement of how many shares Market Makers must buy (or sell) in order to stay neutral as the underlying stock moves.
We measure GEX in terms of how many dollars of security must be bought (or sold) for each 1% of the stock moves.
Positive GEX: Leads to price stability and lower volatility. Prices are often attracted towards significant call strikes, which are usually higher than the current price. This is especially relevant within a persistent trend.
Negative GEX: Indicates potential volatility and uncertain short-term movements. This might result in broader daily trading ranges for the index.