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Gamma Exposure: Understanding the Importance of Delta Hedging

What is Gamma Exposure?

Gamma Exposure, also known as dollar gamma, is equal to half the gamma of the portfolio multiplied by the price of the underlying security squared. It is the change in delta with respect to the underlying price, and it is important because it allows us to read important structural flows in the market. Using Gamma, traders can see the potential delta-hedging activity by market makers.

Exploring the Relationship between Gamma and Delta Hedging

Delta Hedging is the process of reducing or hedging directional risk associated with price changes in the underlying security. The amount of delta-hedging necessary to reduce risk is dependent on important variables, one of which is Gamma.

Gamma measures the second-order price sensitivity of an option or portfolio to changes in the price of an underlying security. It is the change in delta with respect to the underlying price. Vanna is the change in delta with respect to the implied volatility, while Charm is the change in delta with respect to the passage of time.

Gamma, Vanna, and Charm are second-order Greeks that measure the sensitivity of first-order Greeks to changes in factors of the underlying. Arguably the most important and best-known second-order Greek is Gamma.

Long Gamma vs. Short Gamma

When market makers and dealers are long gamma, it means they have positive gamma exposure. A position that is long gamma will have a delta that increases when the underlying increases and a delta that decreases when the underlying decreases. To be long gamma, a trader can buy options (either calls or puts). When market makers and dealers are long gamma, they hedge risk exposure by selling when the market rallies and buying when the market drops.

When market makers and dealers are short gamma, it means they have negative gamma exposure. A position that is short gamma will have a delta that decreases when the underlying increases and a delta that increases when the underlying decreases. To be short gamma, a trader can sell options (either calls or puts). When market makers and dealers are short gamma, they hedge risk exposure by buying when the market rallies and selling when the market drops.

Good Liquidity

To understand structural flows, one must understand what good liquidity is. Good Liquidity can be defined by tight spreads and abundant quotes on both sides of the order book. In markets where liquidity is bountiful, market makers have less trouble reducing risk exposure through delta hedging.

It's important to note that implied volatility directly reflects market liquidity. When the market is liquid, large orders have less of an impact as the order book can more easily absorb the large orders. It is difficult to move a liquid market. In these conditions, there will be lower realized volatility and, therefore, lower implied volatility.

However, when liquidity is low or one-sided, the order book will be thin, which means any large trade can more easily move the market. Consequently, this activity results in higher realized volatility and, therefore, higher implied volatility.

Factors Affecting Gamma

The impact Gamma has is dependent on different factors such as open interest, time to expiry, liquidity, and volatility. Understanding how these different factors affect Gamma is essential in understanding how to use it to read structural flows.

The more abundant the open interest is at a particular strike that has a near-term expiration date, the more likely it is that the Gamma Exposure will have an impact on the market. When there is a significant amount of open interest, it indicates that there is an elevated interest in traders holding positions in the underlying asset, which leads to more activity and more exposure.

At the individual contract level, the gamma is highest for at-the-money options, and the gamma decreases as the option moves further ITM or OTM. Gamma increases as the contract nears its expiration date, especially for at-the-money options. This means that as the expiration date nears, its delta becomes more sensitive to underlying price changes.

The relative strength of the impact that gamma exposure will have is affected by the liquidity of the market. In highly liquid environments, the market is more likely to absorb any structural flows related to delta-hedging and therefore has less of an impact. However, in low-liquid environments, the delta-hedging flows become more noticeable and tend to have a higher impact. Additionally, in environments where volatility is elevated, delta becomes less receptive to price changes in the underlying asset.

Conclusion

Gamma Exposure is a vital tool for traders looking to reduce or hedge directional risk associated with price changes in the underlying security. It measures the second-order price sensitivity of an option or portfolio to changes in the price of an underlying security.

Understanding the factors affecting Gamma, such as open interest, time to expiry, liquidity, and volatility, is essential in understanding how to use it to read structural flows. The Gamma Exposure tools on the Quant Data platform provide real-time data on Gamma Exposure, Vanna Exposure, and Delta Exposure, allowing traders to make informed trading decisions.

In conclusion, Gamma Exposure is an essential tool for traders looking to reduce or hedge directional risk associated with price changes in the underlying security. By understanding the factors affecting Gamma and using the Gamma Exposure tools, traders can make informed trading decisions and take advantage of structural flows in the market.

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