Hedging by options dealers and sudden equity drops

There is a trend where equities while slowly rise over time and then have a sudden drop. The behavior of options dealers is one possible explanation for this trend1.

Dealers take the opposite side of institutional investors hedging their downside. Dealers then have to hedge the option book in a way that slows upward momentum usually (when they are long gamma) and accelerates downward moves (when they are short gamma).

  • To hedge owning a call option they will short the stock. Gains on the call option will be offset by the short and vis a versa because the dealer just wants to make money on transaction fees. Because dealers are structurally long call options, when stock goes up they short more, when it goes down they buy, this tempers the rates of rise and decline. This is delta hedging.
  • However, dealers are also short put positions, to hedge that the dealer sells stocks, price declines are bad for a short put but good for a short sell.
  • “short gamma” - being short a put or call. Being short gamma means you have to hedge by buying increasing amounts in the direction of the movement (for a call you buy stock, for a put you sell stock). Conversely, being long an option “long gamma”, you buy in the opposite of the price move (sell for a call, buy for a put).
  • Hedging a short gamma position increases the price trend, hedging a long gamma position moderates the trend.

References

1.
Wang, J. J. Central Banking 101. (Joseph, 2021).

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