Reuters / Brendan McDermid
- One word continues to pop up in Wall Street explanations about the stock market's ongoing selloff: Gamma.
- As strategists try to identify the source of the selling, many signs point to the short-volatility strategy as a major exacerbating factor.
If you've read any Wall Street explainers about the recent stock market crash, you probably noticed one word keeps popping up: gamma.
Strap yourself in because this is wonky: Gamma is the rate of change in an options contract's delta, which itself measures the rate of change in the price of an option relative to the stock to which it's pegged. So, we're talking about the rate of change in a rate of change on a derivative to a stock.
That's a mouthful, for sure, but there are investors who trade on this kind of stuff. In fact, Cantor Fitzgerald estimates that the total size of gamma strategies exceeds $1.5 trillion right now, making it a clear force to be reckoned with.
These bets can exacerbate moves both to the upside and downside, which can lead to the kind of exaggerated selloff equities saw over two white-knuckle trading sessions, according to Cantor.
An example of these trades are bets against volatility in the market that saw a surge in popularity, but have been getting crushed in the last few days.
"This gamma is a concealed form of leverage," Peter Cecchini, chief market strategist and head of equity derivatives at Cantor, wrote in a client note. "And markets have just now started to demonstrate its impact."
With gamma's role and influence established, it's time to dig into how exactly it shaped the market's catastrophic two-day decline, which saw historically large losses in stocks and spikes in volatility. For the purpose of this explanation, it's important to note that we're discussing the plentiful short gamma positions that were present in the market heading into the stock selloff.
Cantor says that as selling pressure in stocks mounted amid concern over spiking bond yields, investors that were short gamma may have found themselves too short, spurring a "massive whipsaw." Meanwhile, traders were forced to cover short positions on volatility products as well, which in turn pushed the Cboe Volatility Index (VIX) higher as equities plummeted.
As for which investors contributed to this, Marko Kolanovic, JPMorgan's highly influential head of quantitative and derivatives strategy, blames the machines. Long a critic of the price-insensitive forced trading that robo-investors frequently do, he at least partially blames it for the market's rocky ride.
"Short-term momentum turned negative, resulting in selling from trend-following strategies," he wrote in a client note on Monday night. "Further outflows resulted from index option gamma hedging, covering of short volatility trades, and volatility targeting strategies. These technical flows, in the absence of fundamental buyers, resulted in a flash crash."
Morgan Stanley made a similar observation on Tuesday. The firm notes that short-gamma's negative effect on the market may be short-lived, but it still complicates matters for other investment instruments.
"While [the VIX's spike] reduces much of the short gamma exposure in the VIX market, it will create a negative overhang around similar but less exposed products and curtail volatility supply," Andrew Sheets, Morgan Stanley's chief cross-asset strategist, wrote in a report.
Barclays also acknowledged short-gamma's role in the market selloff. The firm attributes the precarious situation there to the rapid rise of volatility-linked leveraged exchange-traded products (LETPs), while also expressing a lack of worry.
"The bulk of the bulk of the LETP negative gamma originates from inverse volatility ETPs," Maneesh Deshpande, head of equity derivatives strategy at Barclays, wrote in a note. "The magnitude of this negative leverage exchange-trade product gamma is now much lower and thus not a major source of concern."