Positive Gamma Evaporates Leaving Stocks With More Downside Risk

Authored by Simon White, Bloomberg macro strategist,

S&P gamma has fallen close to negative, which increases the risk that selloffs are reinforced by dealer selling.

The S&P was down yesterday, but at 1% on the surface not it’s too much to get worried about. However, it belies a rapid fall in dealer gamma, which is now only fractionally above zero.

When gamma turns negative, dealers -- through their option hedging activity -- go from absorbers of price moves to amplifiers of them. When the market rallies, they have to buy, and when the market drops, they have to sell.

Typically, investors sell out-of-the-money calls to harvest extra premium in a rising market and buy OTM puts to protect against downside.

The calls leave the dealers positive gamma and the puts negative it, but as the puts are generally further out of the money than the calls, the dealers are overall positive gamma.

That’s the usual state of play, and means that most of the time dealers are dampening volatility, selling after rallies and buying after selloffs.

But lately it looks as if investor demand for calls has been waning. We can infer that by the drop in call skew.

Put skew has remained steady on the other hand, implying demand for downside protection remains steady also. The net effect is a drop in gamma.

But that means it won’t take much more downside in the index to wipe out the positive gamma of the calls and leave the puts closer to their strikes, adding to the negative gamma position.

The chart below, via SpotGamma, shows the heavy preponderance of put gamma in the S&P, a lot of which are likely to have been bought by investors and therefore represent negative gamma.

This implies that the SPX could slip down into the 6,600s at any moment...

Therefore despite the lack of panic one might infer from a 1% down day in the index, the market’s instability has grown, and deeper selloffs are more likely.