Option trading translates into stock trading via market maker hedging. For instance, if I buy a call option, the market maker will have to buy the stock to delta hedge. Thus, this should translate into an upward pressure on the stock's prices.

I imagine that the impact of option trading is larger on some stocks than others (in causing price movements). For instance, for some stocks, option trading may account for 10% of return variance, but for others the number may be close to zero.

What kind of stocks would have a higher fraction of returns caused by option trading, in your mind?

  • $\begingroup$ It is not clear what you are asking. Can you give more details? $\endgroup$ Jan 28 at 19:43
  • $\begingroup$ @DaneelOlivaw I just modified the question. Is the clearer now? $\endgroup$ Jan 28 at 19:45
  • $\begingroup$ Okay yes it’s clearer now. $\endgroup$ Jan 28 at 22:19

This question reminds me of, many moons ago in a galaxy far far away, the third week of every third month, when the pointyheads who think "vega" is a real word used to start talking about "pin risk" [or "the gamma hammer", if they wanted non-derivative grunts who don't think in Greeks to shut up and listen].

The punchline being that it matters what options the punters have traded vs the banks. Whether they are long or short options (of either type) close to the strike close to expiry.

If the punters are net long of calls and/or puts versus their banks, then the banks are thus on the short side of these trades. If the market rises, the banks have to buy to maintain their delta hedge. If the market falls, then the banks will sell. Adding to pre-existing price pressures thus will tend to pro-cyclically encourage market volatility.

But if the punters are net short of options at that strike, then the opposite applies. Maintaining the hedge will cause the banks to buy the dips, and sell the rallies. Which will tend to suppress market volatility.

All of these effects are (hopefully) obviously most extreme if/when the date is close to expiry, and spot is close to the strike on a glut of options. But the effect then is conditional on the mix of options that investors have traded, versus their banks have to hold. This can then have opposing effects, on the incentive for/against volatile momentum effects in the underlying.

  • $\begingroup$ This is exactly what I have in mind. Are you convinced that such effects are sufficiently sizable to be worth thinking about in the real world? Further, do we know which stocks are more affected by this? $\endgroup$ Jan 29 at 2:17
  • $\begingroup$ Your comment about punters being long puts doesn't seem right? The behavior of a market maker around a strike just depends on if they are long or short that strike - the option type doesn't matter. So the street being net short strikes (puts or calls) would drive up volatility while being long strikes (puts or calls) would tend to suppress volatility. $\endgroup$
    – river_rat
    Jan 30 at 22:00
  • 1
    $\begingroup$ Yes, you are right @river_rat. I even wrote your version in my original draft, and edited it out because I didn't get a piece of paper and double-check for all the up-vs-down mkt call-vs-put scenarios. So I crossed wires on the options delta vs the offsetting hedge. But yes - if you are short gamma, then your options delta will obviously increase in the "wrong direction", requiring a pro-cyclical adjustment to your hedge. And vice versa. Above edited to correct, and thanks for spotting and the correction. $\endgroup$
    – demully
    Jan 30 at 23:27

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