Investment Committee - June 2025

The Unseen Hand: How Derivatives Drive Equity Markets

In the dynamic world of financial markets, understanding the forces that drive price movements is paramount to sound investment decision-making. As we revisit our February 2022 analysis on "The Gamma Effect", we aim to further elucidate the profound impact of derivative transactions, particularly options activity, on equity market performance. This article delves into how we integrate insights from option market dynamics into our investment strategy, offering a nuanced perspective on the mechanisms at play and their implications for our portfolio.

The Growing Influence of Options Trading

Option transactions have ascended to a pivotal position among the factors influencing stock market behavior. The aggregate volume of options traded on US exchanges has witnessed an extraordinary surge, practically tripling since the onset of the coronavirus pandemic and expanding six-fold over the past two decades. This explosive growth underscores the increasing relevance of derivative markets in shaping the broader financial landscape.

Total options volume aggregate for US exchanges. Practically tripled since the coronavirus crisis and grown 6-fold since twenty years ago.

Sophisticated investment firms, leveraging advanced algorithms and strategies, actively engage in the buying and selling of derivatives across a spectrum of financial instruments, including stocks, commodities, and foreign currencies. These firms, whether hedge funds trading on behalf of clients or proprietary trading firms deploying their own capital, have become official market-makers. Their substantial trading volumes mean they effectively facilitate the buying and selling of stocks and options for other investors, thereby exerting an unprecedented influence on capital market prices, especially within US exchanges.

Firms with the largest option activity in the US exchanges

Understanding Dealer Dynamics and Hedging Requirements

It is crucial to understand that option dealers are not engaged in price manipulation. Rather, they are inherently constrained by their own rigorous hedging requirements. When stock prices oscillate between long and short strike prices, option dealers are compelled to buy and sell the underlying stocks and stock indices. This activity generates predictable price paths, an outcome of their need to maintain a Delta-neutral position.

These predictable paths are not monolithic; they are shaped by a confluence of factors, extending beyond a simplistic reliance on Gamma exposure, as often approximated by platforms like http://squeezemetrics.com/. While such tools offer valuable insights, a comprehensive understanding requires delving into the intricacies of Delta, Gamma, Charm, and Vanna.

Key Drivers of Dealer Activity: Gamma, Charm, and Vanna

Delta: This metric represents the percentage of an option trade's nominal amount that requires hedging to neutralize its directional exposure. Delta is in constant flux, influenced by several critical variables:

• Spot price movement of the underlying (Gamma): Gamma quantifies the rate of change of an option's Delta with respect to changes in the underlying asset's price.

  
  

• Passage of time (Charm): Charm measures the rate of change of an option's Delta with respect to the passage of time.

  
  

• Changes in implied volatility (Vanna): Vanna indicates the rate of change of an option's Delta with respect to changes in implied volatility.

  
  

• Position type (call or put option): The nature of the option (call or put) fundamentally alters its Delta characteristics.

  
  

• Position size (how much): The volume of the option position directly impacts the scale of hedging required.

  
  

Gamma: The Gateway to Hedging Flows

Gamma is arguably the most significant factor driving dealer hedging flows, with its impact today dwarfing capital flows stemming from macroeconomic fundamentals. An option's Gamma intensifies as it approaches expiration, making Zero-Days-To-Expiry (0DTE) options particularly influential on an options book. Remarkably, over 60% of all options traded on US exchanges expire within 24 hours, underscoring the immense importance of very-short-term options in overall market activity.

When market-makers hold a long options position, they are inherently long Gamma. This means their Delta becomes increasingly positive as the market ascends. Conversely, if they are short options, they are short Gamma, causing their Delta to decrease during market rallies and increase during declines.

• Long Gamma positions act as a stabilizing force, counteracting recent market movements. If the market rises, dealers with long Gamma sell the underlying; if it falls, they buy. This activity, coupled with increased interest to buy lower and sell higher, helps to contain prices, fostering slow and steady market movements.

  
  

• Short Gamma positions exhibit the opposite behavior. In such scenarios, market-makers not only withdraw quotes from the underlying bid/ask but also actively sell into declines and buy into rallies. Their systems, characterized by speed and indifference to extreme prices, create a unique subset of market participants who prioritize rapid execution to front-run necessary liquidity before market close. It is rare, if ever, to witness a severe market drawdown in the past eight years without option dealers' Gamma being negative on that day. Negative Gamma is a critical indicator of potential extreme market volatility. Therefore, monitoring Gamma like a hawk is essential.

  
  

Charm: The Relentless March of Time

The passage of time, or "decaying" an option's time-to-maturity, has profound implications beyond just the dropping of option premium. As time elapses, the probability of an option expiring in a different state (in-the-money or out-of-the-money) diminishes. In-the-money options are less likely to end up out-of-the-money, and vice-versa.

This temporal decay causes the distribution around an option's strike price to collapse, leading to a rapid and significant shift in the absolute value of an option's Delta from 0 to 100. This non-linear and variable behavior is incredibly important because it creates a directional influence on market-makers' portfolios. Within seconds, or even faster, they may need to hedge either the entirety or none of the underlying stock or index nominal amount.

Vanna: Exacerbating Market Movements

Vanna, a dimension more complex than Gamma or Charm, is critical to comprehend as it can trigger feedback loops that amplify market movements. The recent market behavior provides a compelling real-life illustration. The S&P 500 index experienced an approximate 20% decline from its all-time high, followed by a robust 17% recovery at the time of writing.

This scenario is a classic example of how derivative positions shift as the underlying asset moves. It is, in fact, the underlying mechanism that has cultivated the widespread investor perception that "buying the dip always works"—a strategy that is effective, but only under specific conditions.

When markets undergo significant declines, investors are often more inclined to seek upside exposure through options, as buying calls during periods of nervousness limits potential losses to the premium paid. This behavior leaves market-makers short call options. To hedge, they neutralize their Delta and Vega positions by the end of the day. If the market then experiences even a minor rebound or simply stops declining, a trifecta of simultaneous events occurs: volatility drops, prices move closer to the call strike (increasing its Delta!), and time has passed. While each of these influences is complex individually, their interaction creates an even more intricate dynamic. As dealers now seek to hedge against a position with a larger Delta, lower Vega, and closer to expiry, they inadvertently create a self-reinforcing feedback loop, compelling them to buy the underlying asset daily merely to remain fully hedged. This is exactly what is happening in the markets nowadays. Buy… rinse… repeat.

Conclusion

The profound influence of derivative transactions, particularly options activity, on equity market dynamics cannot be overstated. As chief investment officer, it is imperative that our investment committee fully grasps these intricate mechanics. By understanding the interplay of Gamma, Charm, and Vanna, and their impact on market-maker hedging activities, we can gain invaluable insights into short-term market behavior and anticipate potential directional shifts. Our ongoing commitment to analyzing these sophisticated dynamics allows us to refine our strategies, mitigate risks, and ultimately, enhance the long-term performance of our clients' portfolios. We will continue to monitor these critical indicators closely, adapting our investment approach to capitalize on the nuanced opportunities presented by the ever-evolving derivative landscape.

Authors: John Couletsis and Kostas Metaxas