Option Greeks For The Week: Analyze The Hedging Behavior Of Option Dealers For The Week Of June 5-9

Using the individually categorized methods available in the Volland dashboard, let’s review option dealer positioning to analyze dealers’ hedging behavior on the S&P 500 Index (SPX).

What Is Vanna?

The option greek vanna is the sensitivity of deltas (how much profit you can expect with a $1 increase in the underlying stock price) to changes in implied volatility (IV). It can also be interpreted as changes to vega, based on movements in the underlying.

To be more precise, vanna measures the change in deltas for every 1-point change in annualized IV on that particular option (fixed price volatility).

Dealer vanna positioning is inversely correlated to market trend. In other words, if total dealer notional vanna is positive, the market trend will be negative as long as IV is increasing, and vice versa. On an individual strike basis, positive vanna will act as a magnet while negative vanna will act as a repellent assuming IV is acting in accordance with its spot-vol correlation.

Who Are Option Dealers?

When an option order is received, a middle man, called an “options dealer”, “options market maker”, or “options wholesaler”, is financially incentivized to accept the order. These entities provide essential liquidity for markets to function. Because they are exposed to adverse selection, they are motivated to hedge their risk.

Nowadays, there are only a few wholesaling companies. Currently, most market making is done through algorithms and computers, and there is very little physical trading at an exchange. It is estimated by the Chicago Board of Options Exchange that 85-90% of all option orders are accepted by option dealers.

A Look At June 5-9, 2023

Over the next week, there is positive vanna to the tune of $135 billion. We assume 85% of that is hedged, so every point reduction in IV (using VIX as a proxy) results in $20.25 billion in dealer buying.

Image: Vanna on SPX for all expirations. https://www.vol.land.

This was the primary driver of the rallies on Wednesday, May 31 and Thursday, June 1, as IV plummeted to 14.30. That means IV needs to drop to continue this rally into the June monthly options expiration next week.

IV has not been this low since late 2021. However, realized volatility (RV) is at 12.97. This means IV does not have very far to fall until selling options are negative carry trades – a dynamic that signals a broken market. As a result, you cannot count on much more IV deterioration to create a substantial rally.

Furthermore, if we look at vanna after June expiration, we see a dramatic decline in vanna:

Image: Vanna on SPX for expirations after June 16. https://www.vol.land.

The region between 4000-4150 loses its vanna support, and a lot of the vanna support comes from sold calls that are deep out of the money. So, if IV expands as it should when it is so close to relative volatility (RVOL), there is little support below.

Ultimately, using the vanna profiles, this week should be relatively serene from a dealer hedging standpoint. However, there is a storm brewing in the vanna space. This could cause some volatile weakness past 4000 SPX starting as early as Friday, but more likely should result in downside starting the middle of next week. Be ready to protect yourself from downside during this window.  

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