"Options are not a derivative. They are the underlying. When people refer to options and all the volume increases, the phrase that everybody uses is 'the tail is starting to wag the dog.' I'm here to tell you that options are the dog. My belief is that if you look forward in 20 years, 40 years even, we will be in a completely different world where options sit at the core of investing."

— Cem Karsan

Dealer gamma hedging is a critical concept in options trading that can help traders understand the forces that drive market movements. In this lesson, we’ll break it down step by step, focusing on how market makers adjust their positions and how this impacts the broader market.

Before diving into the lesson I'd like to highlight the unusual quote by Cem Karson above. Cem Karsan, a noted expert in volatility and derivatives, often emphasizes the critical role of dealer hedging flows in market behavior. One of his insights relates to how option dealers' gamma hedging can create feedback loops in market movements. Essentially, when dealers are short gamma, they must sell into declining markets and buy into rising ones, amplifying volatility. Conversely, when long gamma, they act as stabilizers, buying dips and selling rallies, reducing market swings.

Karsan explains that these dynamics are driven by the mechanics of managing large options positions and can significantly influence price action, especially in index-heavy markets like the S&P 500. This understanding is crucial for traders who want to anticipate market trends based on positioning and flows rather than solely on fundamentals.

Cem Karsan frequently discusses dealer gamma hedging and its effects on market dynamics, particularly how the positioning of market makers impacts price movements. Here are a couple of insights from his commentary:

• Gamma's Influence on Market Behavior: Cem highlights how the "gamma positioning" of dealers creates predictable market movements. For example, when dealers are long gamma, they tend to dampen volatility by buying low and selling high. Conversely, when short gamma, their hedging activities can exacerbate market moves in both directions, leading to increased volatility​
• Options Volume and Market Structure: Cem emphasizes the growing dominance of options in trading volumes compared to the underlying equities. He notes that this shift amplifies the influence of gamma hedging, as dealer flows are increasingly dictated by the substantial options activity​

These observations align with Cem’s broader theme that understanding gamma dynamics is crucial for traders aiming to navigate and anticipate short-term market trends. You can explore more about his thoughts on these mechanics in his interviews on platforms like Option Alpha and RCM Alternatives.

What Is a Dealer?

A dealer, also known as a market maker, is an entity or individual that facilitates trading by quoting both buy and sell prices for securities. They provide liquidity to the market, ensuring there’s always a counterparty available for your trades.

When you buy an option, the dealer typically takes the other side of your trade. This means that the dealer is now exposed to risk and must take action to mitigate that risk. This is where hedging comes in.

Understanding Gamma and Delta

Before diving into gamma hedging, let’s review two key Greek terms:

• Delta (Δ): Delta measures how much the price of an option changes relative to the price of the underlying stock. For example, an option with a delta of 0.10 means the option’s price will change by $0.10 for every $1 move in the stock price.
• Gamma (Γ): Gamma measures the rate of change in delta as the stock price changes. Higher gamma means delta changes more rapidly, requiring frequent adjustments to hedges.

How Dealer Gamma Hedging Works

1. The Initial Trade:
   1. Suppose you buy an out-of-the-money call option with a delta of 0.10.
   2. The dealer who sells you this option now has a delta of −0.10 (opposite to your position).
2. Dealer’s Hedge:
   1. To stay delta-neutral (avoiding directional exposure), the dealer buys 10 shares of the underlying stock (since 10 shares × 0.10 delta = 1.0, offsetting the −0.10 delta).
3. Scaling Up:
   1. If more traders start buying similar call options, the dealer’s negative delta position increases, requiring them to buy more shares to hedge. This buying activity can push the stock price higher.
4. Gamma’s Role:
   1. As the stock price rises, the delta of your call option increases (e.g., from 0.10 to 0.50). This forces the dealer to buy more shares to maintain a delta-neutral position.
   2. This cycle of increasing stock prices and higher deltas is called a gamma squeeze.

Example of a Gamma Squeeze

Let’s illustrate with a hypothetical stock, Apex Industries:

1. You and your friends buy out-of-the-money call options on Apex Industries, each with a delta of 0.10.
2. The dealer sells these options and buys shares to hedge their growing negative delta.
3. As the stock price rises, the deltas of these options increase (e.g., to 0.50), and the dealer must buy even more shares.
4. This feedback loop can cause the stock price to skyrocket, attracting more traders and intensifying the cycle.

Real-World Impact: Short Squeeze Meets Gamma Squeeze

When gamma squeezes combine with high short interest, as seen in cases like GameStop, the effects can be dramatic. Short sellers scramble to buy shares to cover their positions (a short squeeze), adding to the upward pressure created by dealer hedging activities.

Key Takeaways for Traders

1. Watch for Clues: Monitor unusual options activity and high open interest in out-of-the-money options as potential signs of a gamma squeeze.
2. Understand the Feedback Loop: Recognize how dealer hedging can amplify price movements, creating opportunities for traders.
3. Combine with Other Strategies: Use knowledge of gamma hedging in conjunction with broader market analysis to identify trading opportunities.

By understanding dealer gamma hedging, you gain insight into the mechanics driving short-term price movements, giving you an edge in the market. Always practice risk management and stay informed about the underlying factors influencing your trades.

As an additional resource, there is a video covering this entire topic which may include some additional content. Click below to view it.