Best of the Week
Most Popular
1. Gold vs Cash in a Financial Crisis - Richard_Mills
2.Current Stock Market Rally Similarities To 1999 - Chris_Vermeulen
3.America See You On The Dark Side Of The Moon - Part2 - James_Quinn
4.Stock Market Trend Forecast Outlook for 2020 - Nadeem_Walayat
5.Who Said Stock Market Traders and Investor are Emotional Right Now? - Chris_Vermeulen
6.Gold Upswing and Lessons from Gold Tops - P_Radomski_CFA
7.Economic Tribulation is Coming, and Here is Why - Michael_Pento
8.What to Expect in Our Next Recession/Depression? - Raymond_Matison
9.The Fed Celebrates While Americans Drown in Financial Despair - John_Mauldin
10.Hi-yo Silver Away! - Richard_Mills
Last 7 days
Is Natural Gas Price Ready For An April Rally? - 8th Apr 20
Market Predictions And The Business Implications - 8th Apr 20
When Will UK Coronavirus Crisis Imrpove - Infections and Deaths Trend Trajectory Analysis - 8th Apr 20
BBC Newsnight Focuses on Tory Leadership Whilst Boris Johnson Fights for his Life! - 8th Apr 20
The Big Short Guides us to What is Next for the Stock Market - 8th Apr 20
USD Index Sheds Light on the Upcoming Gold Move - 8th Apr 20
The Post CoronaVirus New Normal - 8th Apr 20
US Coronavirus Trend Trajectory Forecast Current State - 7th Apr 20
Boris Johnson Fighting for his Life In Intensive Care - UK Coronavirus Crisis - 7th Apr 20
Precious Metals Are About To Reset Like In 2008 – Gold Bugs, Buckle Up! - 7th Apr 20
Crude Oil's 2020 Crash: See What Helped (Some) Traders Pivot Just in Time - 7th Apr 20
Was the Fed Just Nationalized? - 7th Apr 20
Gold & Silver Mines Closed as Physical Silver Becomes “Most Undervalued Asset” - 7th Apr 20
US Coronavirus Blacktop Politics - 7th Apr 20
Coronavirus is America's "Pearl Harbour" Moment, There Will be a Reckoning With China - 6th Apr 20
Coronavirus Crisis Exposes Consequences of Fed Policy: Americans Have No Savings - 6th Apr 20
The Stock Market Is Not a Magic Money Machine - 6th Apr 20
Gold Stocks Crash, V-Bounce! - 6th Apr 20
How Can Writing Business Essay Help You In Business Analytics Skills - 6th Apr 20
PAYPAL WARNING - Your Stimulus Funds Are at Risk of Being Frozen for 6 Months! - 5th Apr 20
Stocks Hanging By the Fingernails? - 5th Apr 20
US Federal Budget Deficits: To $30 Trillion and Beyond - 5th Apr 20
The Lucrative Profitability Of A Move To Negative Interest Rates - Pandemic Edition - 5th Apr 20
Visa Denials: How to avoid it and what to do if your Visa is denied? - 5th Apr 20 - Uday Tank
WARNING PAYPAL Making a Grab for US $1200 Stimulus Payments - 4th Apr 20
US COVID-19 Death Toll Higher Than China’s Now. Will Gold Rally? - 4th Apr 20
Concerned That Asia Could Blow A Hole In Future Economic Recovery - 4th Apr 20
Bracing for Europe’s Coronavirus Contractionand Debt Crisis - 4th Apr 20
Stocks: When Grass Looks Greener on the Other Side of the ... Pond - 3rd Apr 20
How the C-Factor Could Decimate 2020 Global Gold and Silver Production - 3rd Apr 20
US Between Scylla and Charybdis Covid-19 - 3rd Apr 20
Covid19 What's Your Risk of Death Analysis by Age, Gender, Comorbidities and BMI - 3rd Apr 20
US Coronavirus Infections & Deaths Trend Trajectory - How Bad Will it Get? - 2nd Apr 20
Silver Looks Bearish Short to Medium Term - 2nd Apr 20
Mickey Fulp: 'Never Let a Good Crisis Go to Waste' - 2nd Apr 20
Stock Market Selloff Structure Explained – Fibonacci On Deck - 2nd Apr 20
COVID-19 FINANCIAL LOCKDOWN: Can PAYPAL Be Trusted to Handle US $1200 Stimulus Payments? - 2nd Apr 20
Day in the Life of Coronavirus LOCKDOWN - Sheffield, UK - 2nd Apr 20
UK Coronavirus Infections and Deaths Trend Trajectory - Deviation Against Forecast - 1st Apr 20
Huge Unemployment Is Coming. Will It Push Gold Prices Up? - 1st Apr 20
Gold Powerful 2008 Lessons That Apply Today - 1st Apr 20
US Coronavirus Infections and Deaths Projections Trend Forecast - Video - 1st Apr 20
From Global Virus Acceleration to Global Debt Explosion - 1st Apr 20
UK Supermarkets Coronavirus Panic Buying Before Lock Down - Tesco Empty Shelves - 1st Apr 20
Gold From a Failed Breakout to a Failed Breakdown - 1st Apr 20
P FOR PANDEMIC - 1st Apr 20
The Past Stock Market Week Was More Important Than You May Understand - 31st Mar 20
Coronavirus - No, You Do Not Hear the Fat Lady Warming Up - 31st Mar 20
Life, Religions, Business, Globalization & Information Technology In The Post-Corona Pandemics Age - 31st Mar 20
Three Charts Every Stock Market Trader and Investor Must See - 31st Mar 20
Coronavirus Stocks Bear Market Trend Forecast - Video - 31st Mar 20
Coronavirus Dow Stocks Bear Market Into End April 2020 Trend Forecast - 31st Mar 20
Is it better to have a loan or credit card debt when applying for a mortgage? - 31st Mar 20

Market Oracle FREE Newsletter

Coronavirus-stocks-bear-market-2020-analysis

Options Pricing - Covert Gamma, Portfolio Insurance, and STDs

InvestorEducation / Options & Warrants May 30, 2015 - 06:31 AM GMT

By: John_Mauldin

InvestorEducation

By Jared Dillian

This piece requires some knowledge of option pricing, so I’m going to bring everyone up to speed.

This is the P&L diagram of a long call option:


Source: theoptionsguide.com

As you can see, there is a premium paid for the option. If the underlying asset rises above the strike price, the profit available to the option holder is unlimited. Above the strike price, the option essentially behaves like stock (a $1 change in the stock price results in a $1 change in the option price). Below the strike price, the option behaves like nothing at all.

But this is actually the P&L diagram of the option at expiration.

The P&L diagram of the option today looks like this:

Source: optiontradingtips.com

The red line is where we are today. Notice that the line is smooth, not the “hockey stick” shape the option has at expiration. At $25 in the chart above, the stock has about an equal chance of finishing in the money or out of the money.

The slope of the red line is about 0.5. We would call this a “50 delta” option—meaning that the stock has a 50% chance of finishing in the money. It’s actually a partial derivative.

We call this the “delta.” It’s defined as the change in the price of the option for a given change in the price of the stock, as shown below.

Source: maxi-pedia.com

The delta is super important to option market makers. They typically hedge the “delta” of the option with stock so as to remain “delta neutral” (for reasons that are a little too complex for this discussion). If the market maker has a portfolio of options and the underlying asset moves, he will have to re-hedge his delta.

Why? Because the delta itself changes due to gamma. The delta is the first derivative of the change in option price due to the change in the stock. The gamma is the second derivative. It is the curvature of that red line above.

If I am long an option and I hedge the delta, if the stock goes up, I am going to get longer delta, and I will need to sell stock. If the stock goes down, I will get shorter delta, and I will need to buy stock, as shown below.

Source: Bionicturtle.com

Buying low and selling high is good, right? In this example, someone who is hedging a long option is said to be long volatility. If the asset moves around more than he thought it would, he makes money. This is called being long gamma.

The opposite is true with respect to being short options. Through delta hedging, you’re forced to buy when the market goes higher and sell when the market goes lower, so you want the market to move as little as possible. This is called being short gamma, and leads us to our next topic.

Portfolio Insurance

Most people know that something called “portfolio insurance” is blamed for the Crash of 1987, but they don’t really know what it is.

Basically, it was a hedging technique marketed to asset managers that allowed them to limit their losses and participate in the upside. Say you were a mutual fund—basically, you would pretend you had a portfolio of short options, and you would hedge this invisible gamma by selling when the market went down and buying when the market went up.

Pretty ingenious, right? Except, like a lot of things in capital markets, portfolio insurance might work fine if one person does it, but not if everyone does it.

So on that day in October 1987, when the market started going lower, the portfolio insurance programs kicked in, and waves of sell orders hit the market, which triggered more portfolio insurance programs, etc.

I actually like to call this “Covert Gamma.” There was a lot of short gamma out there in the market, but you would never know by looking at the open interest of index options. It was hiding.

Covert Gamma

It is sort of an old equity derivatives parlor game to try to figure out if the Street is long or short gamma, and by how much. Generally the Street is short gamma, because customers tend to be net buyers of options. That means volatility generally is exacerbated, with dealers selling on the way down and buying on the way up.

But sometimes it is worse than others.

I like to think about covert gamma a lot. Like, for the past few years, when everyone has been making jokes about BTD. Buy The Dip. Sometimes they say BTFD, but that is impolite.

So if buyers come in every time the market goes down 5%, the market is really long gamma, right? It’s covert gamma, but it’s still gamma.

And maybe they sell if the market goes up a few percent, further suppressing volatility.

I think we’ve had a lot of volatility suppression in the last six years, principally from the Fed. The Fed has done a lot of things to suppress volatility (QE, ZIRP) and many people, including myself, think that if you keep suppressing volatility, it is going to come out someday, in a big way, and that will lead to even more volatility.

STD

That’s when Buy The Dip turns into Sell The Dip. It’s funny—nobody ever talks about when we cross over into Sell The Dip. It happens. This is a psychological construct, and you can’t measure it. But at some point, people will get sufficiently spooked (by whatever) that they don’t stand there and bid with both hands. They grab a can of peaches and head for the hills.

Well, let me just say this: When things are quiet, that’s when people start putting on portfolio insurance-like structures that require everyone to sell at once.

It’s human nature. People want to protect gains, so they put on stop losses (covert short gamma) or maybe even structured equity derivatives that take them out of the trade if the market goes down x. These are short gamma trades.

In its most basic form, it’s market psychology. I know a few smug longs on Twitter who constantly berate the bears. I don’t know what they’re thinking—probably that they’ll be able to get out if the market goes down 5% or 10%. The liquidity might not be there when they need it.

The very important conclusion here is: I think at any point in the last six years, the market has never been short more covert gamma, and I think tail risk is very high. I am not bearish, per se. But I think the probability that we will get some sort of market dislocation is too high to ignore.

I generally don’t buy tail risk protection, because I think it is overpriced and usually a waste of money. But I will be buying it soon—whether it’s SPX puts, VIX call spreads, VXX calls, or put spreads in HYG, I am going to make sure I’m covered.

I’m not scared. Think of it as putting on a seatbelt. Take it from the guy who usually rides around without one.

Final Note: Bull’s Eye Investor

So as you probably have figured out by now, I’m also the editor of Bull’s Eye Investor  here at Mauldin Economics. I started about eight or nine months ago.

One of the things I’ve been able to do in that newsletter is to dig really deep into topics. It’s about 20-25 pages long, which allows me to research stuff in much more depth than I can for The 10th Man. The piece on the Canadian housing bubble I did a couple of months ago was a pretty good example, and the one on European interest rates last month was a super deep-dive.

Obviously, I think some of the investment ideas are great, but win or lose, I have always focused on the process. I spend a lot of time thinking about how I’m thinking—call it meta-cognition, and if the thought process is sound, the profits will follow.

But maybe a particular issue of Bull’s Eye Investor gives you more ideas or sends you in a different direction—also good. If you can’t find some way to make money with it, you’re probably holding it upside down.

Along the way, we get to talk about some pretty neat stuff (and funny stuff, too). Lots of great brain food. If you like to think big and dream bigger, this is probably for you. And if you don’t like it, there’s always our 90-day money-back guarantee.

I sure hope you will join me.

Jared Dillian

The article The 10th Man: Covert Gamma, Portfolio Insurance, and STDs was originally published at mauldineconomics.com.
John Mauldin Archive

© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules