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I'm trying to confirm that I'm understanding this concept correctly: dealer gamma exposure. I can make sense of dealers / gamma in isolation:

  • Dealers: make markets for certain securities, notching the bid/ask spread in profit. Inventories can be positive or negative, possibly based on assessments of adverse selection.
  • Gamma: change of change

But putting the two together is a struggle for me. Perhaps a worked-out example might help.

Suppose dealer gamma exposure for S&P 500 index futures is -.5. Since dealers take the other side of the trade, then that would mean the buyside is net long index futures, but whether thats by the same amount, I'm not sure.

Since a large portion of the buyside is institutional, conservative strategies, then being net long index futures is likely a hedge for selling equities from their portfolio, I'm thinking out loud.

Question

If dealer gamma is negative, then what, if anything, can we surmise about the prevailing buyside trading and why?
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  • $\begingroup$ This answer might help. Gamma is the second order sensitivity to the underlying, so to be long or short gamma means that we are talking about non-linear instruments, i.e. options. Index futures are linear, so have Gamma equal to zero, it wouldn't make sense to me to talk about dealer Gamma for futures, only for options or bonds. $\endgroup$ May 6, 2022 at 13:35
  • $\begingroup$ Abusing 2 words from macroeconomics we could say: Dealers with negative Gamma act "pro-cyclically": they sell S&P futures if price goes down, buy S&P futures if S&P price goes up. Dealers with positive gamma act "counter-cyclically", they sell if price goes up, buy if price goes down. $\endgroup$
    – nbbo2
    May 6, 2022 at 15:36

1 Answer 1

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If dealers are short gamma, as you say, the client base is long gamma. The explanation for this will not always be the same, but here’s a few possibilities

  1. client base has bought a lot of puts to hedge their long equities position. Frankly this is the most likely persistent explanation, because we see it in the skew profile of otm puts.
  2. client base is nervous about stocks for some reason relating to the current economic situation (war, Fed, etc). So they have bought options to profit from anticipated volatility being higher than implied volatility.
  3. Dealers have issued structured notes / other exotics that are in a hedging zone of negative gamma. Eg variance swaps.

These are just a few reasons why dealers might be short gamma on stock indices.

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