Understanding the GT level
Or the not so invisible hand of the market.
You see me posting the GT level from time to time in the main room, and every day in the GammaOptimizer service, and it is also displayed real-time in the full Variance Center app. But what does it mean? And why is it important?
To better answer those questions I need to start by explaining the acronym. GT is an abbreviation for the Gamma Threshold level. And right there you know that it is related to options (as they are the only equity securities that exhibit Gamma, or Convexity properties). More exactly the Gamma Threshold is computed from options in the S&P 500, all of them, which as today they number more than 11,000 in total. But why do we care about SPX options at all? The answer will be surprising to many of you that are unfamiliar with market microstructure.
The invisible hand of Options Dealers.
Myths have a very interesting property, one way or another they are grounded in some amount of truth. Even though the evil Market Maker myth is false, it doesn’t mean that Options Market Makers don’t have an outsized influence in markets, the reality is that they do. And in modern markets (post-2009) market microstructure has changed dramatically in such a way that hedging activity by a certain type of options market participants has a tremendous effect on the market. The reality of the options market today is that microstructure is getting more complex day after day. In the past, we used to have speculators and MMs, but now Market Makers are dying and they are being replaced by High-Frequency Traders and joined by Volatility Traders (that can be HFT) which are risk-neutral in price but not in volatility (in other words they speculate with volatility). The current picture creates a new breed of participants that in the aggregate I’ll call Options Dealers or Dealers for short.
The common feature of Options Dealers is that for whatever reason, making markets or playing volatility, they are risk-neutral. And here is the key to the effect they have in other markets. You see, in other to be risk-neutral in the options world they need to trade the underlying stock (or basket of stocks) in such a way that they total net directional risk approaches 0.0, in other words, they need to constantly hedge their risk exposure, to make sure that their risk is very low. And it is this action of hedging that has an effect on the market. In its most basic form, hedging means buying or selling shares in the underlying in such a way that the total amount of delta/gamma risk for an Options Dealer remains very small over a window of price changes in the stock (or basket of stocks). Most dealers hedge at certain points during the day: At/near the open, at/near the close, and whenever their delta risk is starting to become too large during the day. Of course, you can imagine that hedging by a single option dealer has a very small effect on the price of a stock and you would be right most of the time. However what happens if the options market is so big that it starts to dwarf the market in the shares themselves? In that case, risk-neutral hedging by options dealers will start to have a noticeable effect on the underlying market.
Index Options Dealers
There is a special segment of options activity and that is the Index options space, in particular, SPX options (and also SPY options in a smaller degree). The Open Interest of the full SPX option chains surpasses 14,500,000 contracts and if you think that each contract commands a multiplier of 100, we are talking about a notional Open Interest of more than $4.4 Trillion dollars which is a staggering amount of money. The size of the SPX options market is incredibly big and getting even bigger. And it is precisely in this space that hedging activity by options dealers has an outsized effect in the overall market. The reason is that the underlying for SPX options is the S&P 500 basket, so hedging activity in SPX options affects all of the 500 stocks that are part of the basket.
The popularity of SPX options and in particular of SPX weekly options (SPXW series) has been in an uptrend for the past several years and most of the new market participants are Volatility players and certain types of low volatility funds. The end result is that recent hedging activity is having an outsized effect in a stock market with dwindling trading volumes (which have been in a negative trend for several years now). In other words as fewer people trade shares, more and more players are trading SPX options, which leave Index Options Dealers as a big source of trading activity during certain times of the day.
Two kinds of Gamma Hedging
Not all hedging activity is the same and it all depends on the sign of the cumulative gamma of a portfolio. Imagine for a second that you are an Options Dealers with just one single short put in your book (you sold a put to a retail buyer). How do you hedge your delta/gamma risk? Because you are short a single put your hedge is also short the underlying (you sell shares of the underlying stock). Now let’s imagine that your book is instead a single long call option (you bought a call from a retailer that wanted to short it), how do you hedge the risk? Again, the hedge is selling shares to hedge the risk. In both cases, your book is long delta, in other words, you make money if the underlying goes up and that is why you go short in both cases for the initial risk-neutral hedge. However, both books are incredibly different from that moment on.
The moment the underlying starts to move hedging becomes very different for both cases. Let’s imagine that the stock is going up in price so we need to hedge our new delta/gamma risk after the move. For the lonely short put book, the amount of deltas to hedge has decreased so we need to reduce the total amount of short shares in the underlying, in other words, we become net buyers of shares when the stock rises (make a mental note of this important fact). Now, what happens if the stock moves down? The deltas to hedge increase and we need to increase our short as well, and therefore, in that case, we become net sellers of shares when price declines (Notice a pattern here?).
Repeating the exercise for the book with the lonely long call. If the stock goes up, the deltas of the Call increase and we need to increase our short hedge, in other words we become net sellers when the stock goes up (compare wit the previous case). Now, if the stock comes down in price, the deltas of the call decrease so we need to decrease our short hedge by covering, so in other words, we become net buyers of the stock when price declines (again, notice a pattern here?)
In the first case (short put) we say we our book is short gamma, and in the second case (long call) we say that our book is long gamma. And as you can see short gamma hedging is very different from long gamma hedging. If the amount of hedging is sizeable short gamma hedging tends to accelerate the moves because we need to buy when the stock goes up, and sell when it is going down. So hedging activity adds fuel and momentum to the prevailing direction. The opposite is true for long gamma hedging as we sell when the stock goes up, and buy when the stock goes down. So long gamma hedging provides a break to the market moves, it slows down momentum quite a bit if the hedging is sizeable.
Of course in real life the book of a given Options Dealers is very complex, as it might contain a mix of long/short calls and puts with many different sizes, but at the end the total gamma exposure and in particular the sign of the gamma exposure can be computed and we can know if he/she is long gamma or short gamma in the aggregate.
The GT level again
And that exactly is what the GT level does. It is a mathematical computation based on a set of assumptions, using publicly available information, to try to estimate the point where SPX options dealers are neutral (gamma exposure is 0). Once that point is computed it is very simple to compare the current value of the SPX index and see if dealers are net-long gamma or net-short gamma. For example, the GT level for yesterday was around 2927 (all in SPX points) and with the market trading above 3013 by the end of the session it means that SPX options dealers are net-long gamma (because we are above the GT level). And after this long post, you can see now why that insight is important. The reason is that hedging activity in SPX options will tend to slow down any moves in the market up or down (because dealers are hedging against the market), which in turn reduces volatility and has a secondary effect of producing residual upside drift (that I leave as homework).
There is also an additional insight to knowing that we are in a long gamma regime. For those of you that are expecting a downside leg in the market, and in particular a big downside leg, notice that a long gamma regime will work against that thesis because hedging activity will try to reverse any sudden big moves down (as we have seen for the past weeks). So it is important to check where the market is with respect to the GT level. Once you see SPX getting closer to it, then the potential to flip short gamma gets really big and consequently the door for bigger moves down also opens. In the meantime, we remain in a long gamma regime and my expectation is that it will last until the end of August at least, so be prepared for very little volatility and upside drift in SPX until then.