Options Gamma Effect Could Cause a Market Collapse

After a record two-month run, the “SPDR 500 (SPY)” suffered it’s 5th largest one day decline on Thursday.  Yesterday we asked whether this was the start of a larger correction. Today, I want to discuss how the nature and structure of the options market could lead to another swoon or possible crash.

First, we start with the put/call ratio has dropped to near-record low levels, meaning over 3 calls were being purchased for every put; it got to the point where skew was completely inverted as people were paying 3x-4x as much for calls than puts. It also means the normal safety net owning puts as portfolio protection has some major holes in it.  So, when stocks start falling the only risk management tool is stop-loss orders, which basically translates into selling at the lows.

The second is how options prices behave and how professionals, such as hedge funds tend to be positioned. Back in my days as a market maker on the floor of the “Chicago Board of Options Exchange (CBOE)” the third Friday of the month was known as ‘gamma day.’ That was prior to 2005 when weekly options were introduced—to show my age, I was on the CBOE from 1991-2002—and ever since ‘gamma day’ has been a weekly occurrence.

Actually, with some Index and ETFs like SPY having expiration three times a week (Monday, Wednesday Friday) Gamma scalping has become a full-time feature of the trading landscape and as this article from the Wall Street Journal highlights, it may be warping price and volatility levels. The nut of the piece is… Continue reading at Stock News

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