While one potential cause of market volatility is essentially theoretical, it has Wall Street opening its eyes to what is referred to in financial jargon as the “gamma trap.” It attempts to explain the violent moves in the market and offers investors potential risk management against it. So what are we talking about? Gamma comes from the Greek letter used in mathematical formulas of options pricing models, and it measures how much the price of an option accelerates when the price of the security it is based on changes.
Thrilling stuff. I wonder how a gamma trap primetime TV show would do against The Bachelor.
If you look at the following graph, you will see the extreme daily volatility that has taken place over the last two years. As much as 5% per day in either direction. To put this in perspective, most investments are pegged to the benchmark S&P 500, which in the long-term averages around 10% per year. Thus, you are now seeing volatility in one day representing half of the annual estimate of the S&P 500.
In a nutshell, this is basically how it works. On one side you have big banks and financial institutions. On the other, you have their clients, pension funds, insurance companies, etc. The banks will provide an investment strategy to these clients, and will hedge themselves by taking the other side of the bet to reduce volatility.
This is done through options, and gamma is the metric. When gamma is positive, options quickly get more valuable when the price of the related shares rise. The bank taking the opposite position to the investor then sells those shares. That damps volatility. When gamma is negative, it is the other way around, and banks buy shares when prices are rising and sell when they are falling.
Always remember to follow the smart money, which unfortunately isn’t you, the retail client. Being able to predict the gamma trap could be incredibly lucrative. Charlie McElligott, cross-asset strategist at Nomura in New York, states, “If you have a good estimate of dealers’ gamma exposure, you can anticipate their hedging flows and pile into that either way.” The impetus for this lies in the fact that large investors don’t have the stomach for market turbulence. As such, Wall Street has created products that will reduce volatility and slightly dampen returns. Kokou Agbo-Bloua, global head of flow strategy and solution at Société Générale, says, “Dealers being long gamma is like a black-hole effect, a negative feedback loop that squishes volatility.”
As witnessed in the graph above, when gamma exposure is strongly positive (right quadrants), the effect on the market is dampened. However, when gamma exposure is negative (left quadrants), there is increased volatility.
The smart money always wins, so how can you benefit from the gamma trap? One could buy the Cboe’s S&P 500 PutWrite index, which can reduce volatility in a turbulent market. Derek Devens, who manages a fund focused on this strategy for Neuberger Berman, remarks, “Returns from index put writing are highly correlated with the S&P 500, but with lower highs and smaller losses.”