Transcription
Option dealers like BlackRock and Citadel use Delta hedging techniques and measure gamma exposure data in order to manage their trading risk. I want to show you how using the same data can give you crucial insights into supply and demand and market direction and really help you step up your trading game.
Here's a great example on the S&P 500. Gamma concentrations have been building at the 4600, 4650, and 4700 levels. These gamma exposure levels had been increasing since the early part of December. I'll explain exactly what Delta hedging and Gamma exposure is later in the video, but for now, just know these are super important levels that option dealers use to make trading decisions and analyze their risk.
From around December 7th through December 13th, we see a ramp-up in the price of the S&P 500 with more gamma exposure coming in at these higher and higher strikes. This is representative of big players in the market speculating, buying out-of-the-money calls to the upside. And so, in these situations, when we see call buying coming in at higher strike prices, we know that option dealers are selling the bulk of those calls. So, this is in speculative scenarios. Option dealers, in those cases, are actually short the calls. And so, in order to hedge their risk, they have to buy futures contracts or SPY shares, which naturally pushes the price higher into those higher gamma concentrations.
On the flip side, you have investors selling calls at the same time in order to generate income. In those situations, option dealers are buying the calls, and in order to hedge their risk, they're selling futures contracts or SPY shares. And so, a lot of times, we see a tug-of-war at these major gamma concentration levels. And this is a result of dealer Delta hedging based on gamma exposure analysis.
Here we see the largest gamma exposure on December 13th was at 4700, and this was a leading signal that market participants think that price is going to move into that level. Option dealers don't have to start hedging in big size until price starts approaching these levels, in which case they will have to exponentially start increasing their hedging by selling futures contracts. This gives a window of opportunity for the market to move higher as more and more call buying comes in. And what do we see happen? Just a couple of days later, the market skyrockets right into that 4700 level and beyond, and then sort of tapers off with option dealers having to really ramp up their hedging by selling, kind of capping the upside.
If we look up further into the options chain, we see that the gamma exposure structure has shifted yet again with the largest concentration at 4,800. This shows us additional speculation coming into the market. So, there's a potential for a move higher from this point forward as another window of opportunity opens up in the next few days where the market can again move higher before increased dealer hedging pressure takes place. So, we'll take a look at a few more trading examples later in the video, but first, I want to analyze what Delta hedging is.
Option dealers use Delta hedging as a risk management strategy in order to minimize exposure to changes in the price of the underlying asset. Delta is a measure of how much the price of an option is expected to change for a one-point change in the price of the underlying stock. So, it can range anywhere from negative one to positive one for both put and call options. So, if an option has a Delta of, let's say, 0.5, it means that for every $1 increase in the underlying stock, the option's price is expected to increase by $0.50. As the price of the underlying asset continues to change, the Delta of the option also changes. And so, dealers are continuously adjusting their positions by buying or selling more of the underlying stock in order to maintain a delta-neutral position.
And this is where gamma exposure comes in. Gamma exposure is a key parameter in the risk management of option dealers, but not only option dealers. Basically, any portfolio manager that incorporates an option overlay into their trading strategy. So, how does gamma exposure work? Well, to understand gamma exposure, we first need to understand the basics of gamma. We've already talked about Delta, which is a first-order derivative, which measures the sensitivity of an option price to the changes in the underlying stock. Gamma is known as a second-order derivative of the option's price, and gamma is basically measuring the acceleration of the Delta. Gamma is highest as the price approaches the at-the-money strike, which increases exponentially until it reaches the at-the-money level.
So, in order to hedge against Delta risk, option dealers and other big market players have to dynamically adjust their positions in the underlying asset. And they do this by measuring the gamma exposure levels, which shows how their portfolio will be affected as a price moves towards various strike prices based on this gamma-fueled price acceleration. So, if we look at an example of a gamma exposure data graph, we can see that there are certain strike prices that have concentrations of gamma exposure. And this goes back to all that speculation or demand that we were talking about at the beginning. If everybody in the market comes in and wants to buy call contracts at a particular strike price, there's going to be a gamma concentration that builds up at that strike level.
And so, option dealers are measuring this gamma exposure to know how much they have to hedge by. Because not only do they measure their Delta exposure, they have to measure their gamma exposure because that's where they get hurt the most. As price approaches the big gamma concentration level, dealers will have to accelerate their hedging activity. We can actually implement a similar analysis to that of option dealers by measuring gamma exposure levels either across the market on the SPY, on the S&P 500, or on individual stocks. When we look at these strike prices that have big gamma concentration levels, we know that these are areas where option dealers are going to be the most sensitive and the most hedging activity will have to take place at these levels.
So, analyzing this data gives us multiple pieces of information. One, it shows us where market demand is, where the most activity is taking place in the market. And two, it also shows us where option dealers are going to be the most sensitive to the price. A lot of times, these major gamma concentrations serve as magnets in certain environments. The price will gravitate to these gamma exposure levels, either to the upside or to the downside. If you want to learn a little bit more about how these different gamma environments work, check out our playlist on gamma exposure. I'll put a link in the description below.
Here's another example, this time on the SPY, the S&P 500 ETF. Back in October, the market had been selling off, and gamma exposure levels at lower concentrations, at 420, at 410, at 400, really started to increase on the negative side, pointing to further downside moves ahead. This situation is a little different because in negative gamma environments, option dealers are forced to sell the underlying security as the price moves lower. So, in this case, investors and traders are out there buying puts at lower and lower strikes. And as price approaches those lower strike levels, option dealers actually have to hedge by selling shares of the underlying security because they have sold those puts and are losing money as price goes lower. In order to offset that, they sell shares of the underlying security. And what do we see? If we just go out a few days forward from this point, we see price trading all the way down to the 410 level. Gamma exposure was leading us every step of the way.
Let's take a look at another example on Tesla. Here we see Tesla has a big gamma concentration at the 250 strike. After a small dip lower, we saw a huge buying spree come in with price rocketing right into that 250 gamma concentration. So, you can see measuring this data provides multiple opportunities and entry points to get in for a move up into those big gamma concentration levels. In this case, we see the same thing. As soon as price hits the 250 strike, dealer selling pressure kicks in, kind of capping the upside on a temporary basis. And that's a good opportunity and a good indication of a level where it makes sense to take risk off the table.
If you guys are interested in adding strategies like gamma exposure data to your trading arsenal, go to our website geeka-finance.com. You can access our gamma exposure dashboard and our trading community Discord. We've got three different price tiers, something for everybody. We cover a number of tickers, ETF stocks, crypto. So, definitely check that out, sign up. We'd love to have you join our community. Thanks so much, everybody, for watching. We'll see you guys in the next video.