Understand the mechanism behind gamma exposure on trading
Market makers have buy and sell options from and to traders, and in order to avoid going bankrupt, they must hedge their market risk by purchasing or selling the underlying equities or futures. This approach is complicated because options behave differently in relation to the underlying market depending on how far they are from their strike price, and this sensitivity varies continually. When dealers are heavily exposed to this shift (the gamma), they must purchase or sell futures contracts at every point the market moves in order to update their hedge (delta hedging) and remain neutral to the market’s direction.
This dealer gamma exposure can be long or short, with opposite impacts, and can amount to billions of dollars in forced supply and demand for each point the S&P 500 Gamma Exposure moves.
If they are long gamma, they must sell shares or futures by the net gamma amount for each point the S&P 500 rises (see chart), and when it falls, they must purchase. Volatility is repressed by this steady force of supply and demand acting in the opposite direction of the market — this is what we frequently see in the shape of slowly rising markets or protracted sideways swings fluctuating in a tight band around one price point. Price looks to be stable at a particular level.
In this case, the opposite impact occurs: for every point the S&P 500 Gamma Exposure falls, traders must sell equities or futures, compounding the market’s decline. Volatility skyrockets, sending equities into a tailspin.
The zero gamma level
Long gamma turns to short gamma at a specific point in a declining market (the “volatility trigger” or “zero gamma level” in the chart) – a critical location at which market behaviour can shift substantially.
Delta and gamma exposures often alter considerably on expiry days based on how expired options contracts are rolled forward, causing abrupt increases in market price as dealers hedge these changes. Because the effects of gamma exposure also fade with time, important market fluctuations and turning points frequently occur around monthly OpEx dates.