How Options Gamma, Vanna and Charm Flows Move the Markets

Summary

This video script narrates the story of 'Gary the Gorilla,' a metaphor for market makers in the S&P 500 options market. It explains how option greeks—delta, gamma, vanna, and charm—affect market dynamics and the underlying stock market. The script uses a blend of humor and financial education to demystify complex trading concepts, illustrating how dealers' hedging activities can influence market movements, especially around options expiration.

Takeaways

• 🦍 The main character 'Gary the Gorilla' symbolizes dealers and market makers in the S&P 500 options market, highlighting their role in providing liquidity and taking on risk.
• 📈 Gary's delta hedging strategy is crucial for managing the directional risk of the options he trades, which requires constant rebalancing based on market movements.
• 🍌 Gary's love for bananas is a metaphor for liquidity, which is essential for his business and impacts the pricing and availability of options.
• 📊 Implied volatility and market liquidity are inversely related; abundant liquidity leads to lower implied volatility, while scarcity results in higher volatility.
• 📉 The client demand for out-of-the-money puts and calls influences Gary's position, often leaving him short out-of-the-money puts and long out-of-the-money calls.
• 🛠️ Gamma measures the rate of change of delta relative to the underlying asset's price, and it's significant for dealers like Gary as it dictates the need for rebalancing delta hedges.
• 📉 Vanna represents the sensitivity of delta to changes in implied volatility, affecting how much dealers need to adjust their hedges as volatility fluctuates.
• ⏳ Charm reflects the sensitivity of delta to time decay, with options losing value as they approach expiration, impacting dealers' hedging strategies.
• 🌐 The collective actions of dealers like Gary in delta hedging can have a substantial impact on the underlying market, especially with large open interest positions.
• 📅 The dynamics of gamma, vanna, and charm are particularly pronounced as options approach expiration, influencing market movements and creating potential windows of weakness.
• 🔍 Understanding these Greek dynamics can provide insight into market behaviors, especially around options expiration (opex), offering a framework to interpret S&P 500 movements.

Q & A

Who is the main character in the video script, and what does he represent?

The main character is Gary, a gorilla who represents the dealers and market makers in the S&P 500 options market. He is responsible for providing liquidity to the market by allowing other players to trade options against him.

What is the significance of Gary's bananas in the script?

Gary's bananas are a metaphor for the liquidity he enjoys in the market. The more bananas he has, the more liquidity he has, which is beneficial for his business as a market maker.

What does 'delta hedging' mean in the context of options trading?

Delta hedging is a strategy used by options traders, like Gary, to neutralize the directional risk of an option's position by taking an offsetting position in the underlying asset. This is done to maintain a delta of zero, which means the position is not affected by small changes in the underlying asset's price.

How does the script describe the typical behavior of portfolio managers in the market?

The script describes portfolio managers as being driven by both fear and greed simultaneously. They demand protection through options, such as buying out-of-the-money puts, while also looking to profit by selling out-of-the-money calls, which contributes to the market's dynamics.

What is the role of implied volatility in determining the price of options?

Implied volatility is a measure of the market's expectation of the volatility of the underlying asset's price. It directly affects the price of options, with higher implied volatility leading to higher option prices and vice versa.

How does the script explain the relationship between liquidity and implied volatility?

The script explains that when market liquidity is high, with many orders on both sides of the bid and ask, it is difficult to move the market, resulting in low realized volatility and therefore lower implied volatility. Conversely, when liquidity is low or one-sided, the market can be easily moved, leading to higher realized and implied volatility.

What is 'gamma' in the context of options trading, and how does it affect Gary's trading strategy?

Gamma is the rate of change of an option's delta with respect to changes in the underlying asset's price. It affects Gary's trading strategy because when he is long gamma, like with out-of-the-money calls, he needs to sell more of the S&P index as the index rises and buy back some as it falls to maintain his delta hedge.

What are 'vanna' and 'charm', and how do they differ from gamma?

Vanna measures the rate of change of an option's delta with respect to changes in implied volatility, while charm measures the rate of change of delta with respect to the passage of time. Unlike gamma, which is about changes in the underlying price, vanna and charm are concerned with changes in implied volatility and time, respectively.

How do vanna and charm influence the market during the approach to options expiration?

As options approach expiration, vanna and charm can cause deltas to decrease, especially for out-of-the-money options. This can lead to significant rebalancing of hedges and can result in substantial index flows, potentially moving the index higher, particularly in the run-up to expiration.

What is the 'window of weakness', and how does it relate to the S&P 500 index?

The 'window of weakness' refers to the period after options expiration when the stabilizing effects of gamma, vanna, and charm are no longer present in the market. It does not necessarily mean the index will crash, but rather that it is more susceptible to other market-moving factors during this time.

How does the script suggest that understanding these option dynamics can benefit market participants?

The script suggests that understanding these option dynamics can help market participants explain some of the behaviors of the S&P 500, especially around options expiration. It can provide insights into market movements and potentially inform trading strategies.

Outlines

00:00

🦍 Introduction to Gary the Gorilla and Market Making

This paragraph introduces the main character, Gary, who is a metaphor for market makers in the S&P 500 options market. Gary provides liquidity for various market players and is responsible for delta hedging his positions. The paragraph explains how Gary's actions can influence the market due to his significant role in the options market. It also sets the stage for a deeper dive into the dynamics of options trading and the impact of market makers' positions on stock prices.

05:00

📈 Delta Hedging and Market Liquidity Impact

This paragraph delves into the specifics of delta hedging, a strategy used by Gary to manage the directional risk of his options positions. It explains how market liquidity, measured by the spread and depth of the order book, affects Gary's ability to hedge and the pricing of options. The paragraph also discusses the relationship between liquidity and implied volatility, highlighting that abundant liquidity leads to lower implied volatility and vice versa. The summary emphasizes the importance of understanding these dynamics for market participants.

10:00

🌟 The Role of Gamma, Vanna, and Charm in Options Trading

This paragraph introduces advanced option Greeks—Gamma, Vanna, and Charm—which measure the sensitivity of an option's delta to changes in the underlying price, implied volatility, and time, respectively. It describes how these Greeks influence Gary's hedging activities and the market's behavior. The summary explains that being long gamma can act as a market stabilizer, while Vanna and Charm can cause significant market movements, especially as options approach expiration. The paragraph also discusses the 'window of weakness' post-expiration, when the effects of these Greeks diminish, potentially leading to market fluctuations.

Keywords

💡Volatility Portfolio Manager

A volatility portfolio manager is an individual who specializes in managing investment portfolios that are designed to profit from or hedge against market volatility. In the video, Carson, the manager, is known for his expertise in options and the Greeks, which are metrics used to measure the sensitivity of options' value to various factors. His role is central to the video's theme of understanding market dynamics.

💡Option Greeks

Option Greeks are financial derivatives that measure the sensitivity of an option's price to various factors. The Greeks include Delta, Gamma, Vega, Theta, and Charm. In the video, the Greeks are personified as market forces, with Delta representing the rate of change of an option's price relative to the underlying asset's price, and Charm being a measure of the rate of time decay of an option's delta.

💡Market Maker

A market maker is a firm or individual that stands ready to buy and sell securities or options at any time, thus providing liquidity to the market. In the script, Gary, the gorilla, metaphorically represents market makers in the S&P 500 options market, emphasizing the importance of their role in facilitating trades and maintaining market liquidity.

💡Delta Hedging

Delta hedging is a strategy used by market makers to manage the risk associated with the price movement of an underlying asset in an options contract. It involves adjusting the position in the underlying asset to offset the change in the option's delta. In the video, Gary delta hedges to maintain a neutral position, which is crucial for his business operations.

💡Liquidity

Liquidity refers to the ability to buy or sell an asset quickly and easily without affecting its price. In the context of the video, Gary appreciates liquidity as it allows him to hedge his positions without significant price impact, which is essential for his business model.

💡Implied Volatility

Implied volatility is a measure of the market's expectation of the volatility of an underlying asset's price over a certain period. It's derived from the price of an options contract. The video explains how implied volatility is influenced by market liquidity and can affect the pricing of options.

💡Gamma

Gamma is one of the Greeks and represents the rate of change of an option's delta relative to the change in the price of the underlying asset. In the video, gamma is depicted as a significant factor in Gary's delta hedging strategy, especially when the market is moving, affecting how he needs to adjust his positions.

💡Vanna

Vanna is another Greek that measures the rate of change in an option's delta relative to a change in volatility. In the video, vanna is used to illustrate how changes in implied volatility can affect the delta of options, which in turn influences Gary's hedging activities.

💡Charm

Charm, as mentioned in the script, measures the rate of change in an option's delta with respect to the passage of time. It's a lesser-known Greek but is crucial for understanding how time decay affects options, particularly as they approach expiration, which is a key point in the video's narrative.

💡Expiration (Opex)

Expiration, or 'opex' as referred to in the script, is the date on which an options contract becomes invalid if it has not been exercised or closed out. The video discusses how the approach of expiration can intensify certain market dynamics, such as increased gamma, vanna, and charm effects, impacting Gary's hedging strategies.

💡Window of Weakness

The 'window of weakness' in the video refers to a period after options expiration when the market is no longer influenced by the hedging activities of market makers. This period can be seen as a time of market vulnerability to other external factors, as the stabilizing effects of delta hedging are temporarily absent.

Highlights

Jam Carson, a volatility portfolio manager, popularized option greeks such as vanna and charm and uses emojis to represent market forces in his tweets.

The video aims to demystify the greeks, the flows, and the emojis used in financial market discussions.

Gary, a gorilla metaphor for market makers in the S&P 500 options market, represents the dealers providing liquidity for options trading.

Delta hedging is a primary strategy for Gary to manage directional risk in his options trading.

Liquidity in the market is crucial for Gary's business, affecting his ability to hedge and the cost of options.

Implied volatility is directly related to market liquidity; abundant liquidity leads to lower implied volatility.

Portfolio managers' trading behavior influences Gary's book, often resulting in a short position in out-of-the-money puts and a long position in out-of-the-money calls.

Gamma measures the rate of change of delta in response to the underlying price, impacting Gary's need to rebalance his delta hedge.

Vanna quantifies the change in delta with respect to implied volatility, affecting how Gary's hedging strategy adjusts.

Charm measures the rate of change of delta over time, another factor in Gary's dynamic hedging strategy.

Long gamma positions act as market stabilizers, buying dips and selling rallies.

Significant gamma exposure can pin the index within a specific price range, demonstrating the dealers' market influence.

Vanna and charm flows are most pronounced during the second and third weeks of the month, affecting the S&P index's movement.

The week of options expiry (opex) sees a decrease in vanna and charm effects, opening a window of non-strength for the index.

Post-opex, the absence of vanna and charm flows means the index is more susceptible to other market-moving factors.

Understanding these option-related flows can help explain some dynamics of the S&P 500, especially around opex.

The video concludes by emphasizing that these market dynamics are not an exact science but understanding them can be valuable.

The narrator hints at future videos covering other financial topics, such as 'lemons', encouraging viewers to subscribe.

Transcripts

gorilla's bananas are you serious is

this is this for real

how do i even present this

and when gary cannot get his bananas oh

that makes him very angry

and that's when prince charming comes

around and opens a window of weakness i

can't i just can't do this

you're probably wondering what was that

all about

i understand because even if you've been

following financial twitter you might

not necessarily be familiar with jam

carson jam is a volatility portfolio

manager and is famous for popularizing

such option greeks as vana and charm

when he shares his market views on

twitter he often discusses option

dynamics and the impact they have on the

underlying stock market but what makes

him different is his unrestricted use of

emojis his tweets often feature

different emoji characters which

represent various market forces if

you're not familiar with these market

forces or emojis it might be difficult

to understand what is going on

in this video we are going to demystify

the greeks the flows and the emojis and

discuss how dealer option positioning

affects the underlying stock market

let's get into it

[Music]

hello and welcome sergey here on this

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to have you on board

so

let's start the story

enter our protagonist he's good looking

he's gorgeous he's golden age is a

proper handsome

his name

is gary his name is gary

gary is a dealer

he is the market maker in s p 500 index

options he makes it possible for hedge

funds pension funds portfolio managers

and other market players to trade their

options against him

he provides liquidity

oh and he's also a gorilla

[Music]

metaphorically gary represents all the

dealers and market makers in the s p 500

options market quite a massive chunk of

s p options volume goes through him

he's a big gorilla i mean look at him

he's a real risk taker once someone

trades options with him it's very rare

that gary can make the same offsetting

trade against someone else after all

he's not a broker it's great when it

happens but most of the time he's just

left to sit there on the risk and

warehouse it on his books

so the first thing gary does is to delta

hedge and remove the option's

directional risk he hits es1 index mdm

go on his bloomberg and checks the order

book and it looks fantastic tight spread

on the best bit and offer lots of quotes

on both sides and with decent size too

there is some good market depth in there

gary likes what he sees

all that liquidity means that he'll have

no issues hedging his delta in either

direction

that's good for business it is good for

business with delta hedging not an issue

gary can afford to sell the options

cheaper and make more volume

equally when buying options he wouldn't

pay for them more than he can recover

from delta hedging them especially since

it's difficult for the index to make any

meaningful moves with so many quotes in

the order book

and so he remarks the entire wall

surface lower as you can see from this

example it is often that implied

volatility directly reflects the market

liquidity if the liquidity is abundant

there are many orders in the order book

on both sides of bit and ask

if a large order comes in it'll be

easily observed by the market and won't

have a significant price impact

hence it is very difficult to move a

liquid market

as a result realized volatility will be

low

which will also be reflected in a lower

implied volatility

on the other hand if the liquidity is

inadequate or one-sided

the order book will be thin

and any relatively large order can

easily move the market

this will result in a higher realized

volatility and consequently in a higher

implied volatility

to summarize as liquidity deteriorates

implied volatility moves higher

or as liquidity improves implied

volatility

falls

and gary likes his liquidity like he

likes his bananas the more he has the

better it is

and on this quiet summer day he's got

lots of bananas

[Music]

but even during the summer all those big

portfolio managers are keeping gary very

busy

it's usually said that it's either fear

or greed that dominate the market at any

one time

but with portfolio managers it seems

that both of these emotions are dominant

simultaneously somehow they manage to

manifest themselves within a single

individual as a result gary's client

overflow usually takes shape in the form

of downside buying and upside selling

everyone wants protection but at the

same time everyone wants to make some

extra money anywhere they can

in part to help pay for that same

protection as it ain't cheap

as a result of this flow there is lots

of demand for out of the money puts and

quite a bit of supply of out of the

money calls

consequently the dealer's book is mostly

short out of the money puts

and long out of the money calls

this of course needs to be delta hatched

which forces gary to sell s p index for

both

the put side and the call side

this way any positive delta from the

option's position is offset by the

negative delta from the short s and p

position resulting in an overall delta

of zero

after the book is hedged gary's got a

minute to grab a quick coffee and a

croissant but he's not done what matters

now is how the delta changes as it moves

around gary will need to rebalance his

delta hedge by trading in the underlying

and this trading activity is not

discretionary he is completely at the

mercy of his delta in order to stay

delta hedged he must trade the s p as

directed by his delta changes and keep

in mind gary is a big gorilla he

controls a significant portion of snp

options flow his delta hedging activity

is far from trivial the rebalancing

flows are meaningful and frequently

impact the underlying market

wouldn't it be great

to know in advance what these flows are

going to be

the size and direction of these flows

depend on how much dealer's delta

carries delta wanders around and that in

turn depends on changes in underlying

price changes in implied volatility and

the unstoppable marching of time that is

slowly guiding us all towards an

inevitable death

the effects of these quantities are

measured by gamma vanna and charm

respectively

gamma is a change in delta with respect

to underlying price

vomit is a change in delta with respect

to implied volatility and charm measures

the change in delta with respect to

passage of time

okay here's the big picture at the

moment if it's a quiet summer day and

the market has been slowly grinding

higher

gary finds himself sitting around this

long out of the money calls territory

where he is long gamma

if the index rises his options delta

will increase towards 1 as options get

closer to the money

and he'll need to sell more of the s p

index in order to counter that

on the other hand if the index falls

his options delta will decrease towards

zero as options get further out of the

money and he'll need to buy back some of

his s p shorts in order to offset this

tightly packed isobars on the northern

flank of that means easterly wind in

summary if the dealers are long gamma it

means that they're buying the dips and

selling the rallies which acts as a

stabilizer for the market

and if the long gamma exposure is

significant for example a large open

interest

it works as a magnet and pins the index

around a certain price range

[Music]

as we move towards options expiry week

the gamma for at the money options

increases significantly and can further

dampen the index moves apart from

gamma's stabilizing flows there are also

vana and charm flows

for out of the money options delta moves

towards zero as implied volatility drops

or as the option approaches expiry

under normal market conditions implied

volatility term structure is incontango

and is upwards sloping this means that

for a slightly out of the money option

we would expect its implied volatility

to decrease as the option approaches

opex it would just roll down the term

structure

and this change in implied volatility

causes delta to decrease as measured by

vana

[Music]

but vana is not the only thing that

decreases delta there is also charm

as we get closer to expiry out of the

money options become cheaper and their

deltas tend to zero

together with vana charm is guilty of

lowering deltas as options approach

their due date

and since gary's positioning is mostly

long are the money cause a lower delta

means he needs to rebalance his hedge

and buy back some of his s p shorts now

i say some but given the size of his s p

options book buying some s p index can

in fact result in quite significant

index flows and move the index higher

especially in the run-up to opex the

effects of varna and charm are the

strongest during the second and third

week of the months as in the opex week

and the week before

these flows are frequently guilty of a

slow grind higher that we usually see in

s p index in the run up to opex

as we move towards the middle of the

opex week the vana and charm flows start

fading away part of these flows come off

the table when we hit the expiration on

wednesday making an opening for the

window of weakness

after the opex gamma vana and charm

expire

and the index is free to do

whatever it is that indices do when

they're not subjected to options hedging

flows

this is when vana and charm go on a

holiday and their flows aren't present

to support the market

however the window of weakness does not

necessarily mean the index will crash

it's not a window of weakness it's a

window of non-strength and that just

means the index has stopped flirting

with vana in charm and is open to other

relationships hence it's more

susceptible to other market moving

stories during this time

at around the end of the months vana and

charm start coming back and begin having

an effect again

well that was the story of gary

thanks gary of course these dynamics and

flows aren't an exact science they

largely depend on dealer positioning

where open interest is what level the

volatility is at and how much is it

moving

nonetheless understanding these flows

can help explain some of the dynamics of

s p 500 that we see around opex

[Music]

thank you very much for watching i

really hope you enjoyed this video apart

from bananas i'm also planning to cover

such things as lemons in my future

videos so if you want to see that please

hit the subscribe button thank you very

much i'll see you in the next

[Music]

one forget to like and subscribe

[Music]

sweetie

[Music]