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Say, an investment bank want to hedge its Long Gamma position on its Long Call option by placing limit orders in the exchange. Limit orders result in increasing volume depth.

Empirically, what is the effect to stock volatility?

Does the increasing depth make it harder for stock to move up or down?

Does the increasing depth attract other market participants to trade stocks and improve price discovery?

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closed as too broad by Gordon, vanguard2k, Quantuple, olaker Feb 21 '17 at 6:23

Please edit the question to limit it to a specific problem with enough detail to identify an adequate answer. Avoid asking multiple distinct questions at once. See the How to Ask page for help clarifying this question. If this question can be reworded to fit the rules in the help center, please edit the question.

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Answers to your 3 questions:

  1. Empirically, there is no effect. I understand that this is not logical but it is reality.

  2. Adding thickness to an order book does not necessarily make it harder or easier for a stock to move. If your order is static it will be recognized quite quickly and used by other participants for liquidity.

  3. It will attract participants but not necessarily to improve price discovery. It may attract predatory traders as well that could increase short term volatility.

Regarding the first sentence of your post...if you are concerned about the long gamma exposure of a long call option you must be holding an option that is very close to expiry and very close to being at-the-money. There are far more effective ways to hedge/mitigate that risk rather then trying to stack an order book at an expiration to make a stock appear stable.

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  • $\begingroup$ that last paragraph is exactly my concern! There is no other close related derivatives I can offset. Can you share some effective ways you've mentioned. $\endgroup$ – Jack JackGuRae Feb 15 '17 at 14:48
  • $\begingroup$ If the situation that I have assumed is true (hold ATM calls into expiry) then your biggest concern should be the negative Theta you are holding. Meaning that your entire position (or most of it) is extrinsic value. You could sell a call above it and create a spread (this would reduce your theta, delta and gamma exposure). You could roll it to another expiry. A horizontal roll would result in a debit but would also reduce theta, delta and gamma. It you don't care about Theta or delta and just want to neutralize gamma you could buy puts and turn it into a straddle (gamma neutrality). $\endgroup$ – amdopt Feb 15 '17 at 14:54
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Consider this: If there is infinite volume available at both bid and ask, then the price of the asset will never move irrespective of the size of the incoming market order, the mid will always be the same. 0 volatility.

There are traders who use quantity available at a price as a resistance and support and trade accordingly.

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limit orders (buy orders below the market, sell orders above the market) obviously reduce volatility all other things constant, by acting as a kind of partially absorbing barrier against incoming trades (i.e. makes it harder for noise traders to move the price up or down).

On the second question liquidity is to some extent self-reinforcing, more depth means lower transactions costs, which attract more traders, which further increases depth and liquidity and at least in theory leads to better price discovery (now we are taking about the information traders).

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  • $\begingroup$ An interesting example is a "fat finger crash" where some idiot enters a big sell order by mistake (a typo). If there are plenty of buy limit orders below, the price will crash less, if there are not the price will drop quite considerably, at least for a while until new traders come in and re-establish an equilibrium. $\endgroup$ – noob2 Feb 15 '17 at 12:58
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Once your daily gamma start approaching a reasonable fraction of DV, those resting order will start killing vol (if anyone tells you otherwise, they just haven't reached that threshold). Usually you see this effect on large corporate trades such as ASRs or large stake acquisitions.

As an curiosity, one of the HF traders used to be called "the put bomber". He'd quote a high gamma put (gently OTM) on a semi-liquid stock and hit a few desks at once. Obviously, once the size in the market was meaningful, the vol would be squashed from delta hedging. Eventually, most people cut him off, of course.

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