How Market Makers Hedge In Negative Gamma

Today let’s touch again on what being in negative gamma means. Let’s start from a thread we wrote about how market makers hedge themselves when they are in negative gamma.

• For market makers to be short gamma, investors have to buy options.
• To stay delta hedged in negative gamma, Market Makers sell underlying.
• As investors buy more options, Implied Volatility increases, which decreases market gamma creating a new exposure to Market Makers: Vanna, and that has to be hedged just like gamma.
• The drop in price, like we have seen recently, gets investors to buy OTM puts.
• This creates more negative gamma.
• Market Makers have to sell more to stay delta hedged as prices move down.
• That leads to more volatility and Market Makers have to keep selling to hedge Vanna.

This is the activity we have been seeing recently, where the Put support level continues to shift lower as investors continue to bid OTM puts to hedge their portfolio. This for MM creates negative gamma + vanna that can become a vicious cycle.

Source: Twitter @MenthorQpro  

Now there are a couple of things to keep in mind. 

• One is that when Put Support moves down that tends to be bearish for the market because of market makers repositioning. What we like to do in this case is take note of the 1D Move to see how wide the move is and if it looks to break below that Put Support.
• Another thing to keep in mind is that when the market is in negative gamma, the price moves during the day tend to be very large, meaning that the 1D Min and Max come into play as we have seen yesterday.
• A negative gamma and a red Option Matrix is mainly a sign of high volatility. That is important, because when people see a red Option Matrix they automatically become bearish, while that can happen if certain levels are broken the main takeaway has to be the volatility regime.

Source: Twitter @MenthorQpro

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