Gamma zero: an overlooked signal of volatility is flashing red

Markets are most erratic when option hedging exposures are flat

Options dealers know only too well the dangers of short gamma positioning, which causes hedgers to sell into falling markets, triggering further price falls and more selling by hedgers – a feedback loop known as a gamma trap.

Less well understood is how the gamma positioning of dealers might signal turbulence even when dealer exposures are flat — when the trap, so to speak, is not loaded.

Traders and investors know that markets are more volatile when gamma exposures are negative, says Garrett DeSimone, head of quantitative research at options data firm OptionMetrics. “What’s less widely known is that markets are at their most volatile when gamma is at zero.”

OptionMetrics estimates exposures by tracking data on the volumes of options written at different strikes. A graph of its estimates plotted against volatility in US stocks illustrates the point DeSimone refers to.

 

Volatility is greatest when the Street’s gamma exposure is neither positive nor negative, it turns out. This isn’t to say negative or so-called short gamma isn’t the problem markets have long thought it to be. But flat gamma, it seems, is cause for worry too.

Gamma zero could be compared with the event horizon of a black hole where normal rules cease to apply, DeSimone says. “When you get closer to that zero value, markets become totally out of whack.”

The influence of gamma is one of the more complex structural elements in markets. The term refers to the rate of change in an option’s delta as the price of the underlying moves.

Dealers build up exposure when they write options, the values of which change more violently the closer the spot price of the underlying is to the option’s strike.

When they are short gamma, in a sell-off they are forced to pare those hedges aggressively – selling as prices fall; the deeper the drop, the harder dealers have to sell.

The dynamic has been blamed for flash crashes, and the wrong kind of exposures cited as the cause for failing strategies. Quants that trade intraday trends watch gamma indicators closely, such is the influence of hedging flows on late-session price moves.

Positive gamma exposures have the opposite effect, dampening volatility. Dealers that are ‘long gamma’ add to their hedges when prices fall, meaning they buy assets.

 

Flat gamma, though, is a different case entirely. It indicates that dealers are holding more balanced books, DeSimone says, probably because they are nervous about the market outlook. It means firms are hiking the price of options – making protection more expensive for investors – so as to write fewer contracts and so reduce the need to hedge.

When gamma is flat, then, markets jump because investors are less well hedged and because the absence of dealer hedging reduces market liquidity.

Gamma zero does not always create volatility, of course. Other factors – inflation, rate hikes, wars, and so on – commonly play the lead role. Equity volatility has remained oddly low this year despite gamma exposures at much lower levels than in 2018 and 2019, for example.

Yet the flattening of exposures has been a feature of markets since the Covid pandemic struck in March 2020 (see figure 2). And a concern now is that such a flattening could point to elevated volatility in future.

“It looks like dealers are unwilling to hold big gamma positions anymore,” DeSimone says.

In an uncertain macroeconomic environment, dealers pulling back from offering protection cannot be good news for investors.