Introduction to Gamma Exposure(GEX)

May 21, 2022

In this week’s option blog we introduce the concept of Gamma Exposure (GEX) and the practice of option strategy using GEX as indicator.

01. What is Gamma Exposure

In past blogs we have introduced option greeks, where we define Gamma as change of rate on Delta given unit change of option underlying asset price. Gamma describes how fast the option value changes when the stock price changes a unit. In practice Gamma is a “gold mine” that often helps us effectively excavate trading opportunities. This is because Gamma plays a significant role in building a successful delta neutralization strategy and dynamic hedging. Gamma is also a core indicator that market makers would constantly monitor on. As the main opponent of mass traders, market makers has a huge demand over dynamic hedging to maintain their delta neutral condition and avoid directional risk as possible to play their bid and ask games. Market makers are often described as “giants in the market” as they influence the liquidity of the market and bid-ask spread using their informational and capital edge. However, on the flip side it is hard to totally hide a giant’s footstep in the market as their movement has momentum impact. Therefore, we as normal traders and investors with relatively small money pool can trace the footstep of giants and deduce their intention. If we can effectively analyse possible expected action from market makers and their footsteps, we would own a unique edge in the market. GEX indicator is exactly such a tool that can help us monitor the footsteps of market makers.

GEX by definition is calculated as the total product of call open interest of selected option and call gamma minus the total product of put open interest of selected option and put gamma:

GEX = call open interest * call gamma - put open interest * put gamma

As we know Gamma is always positive in a long option position and negative in a short option position. That is to say if we observe a positive GEX, the market has more net open interest in call option with buy-in intention (positive gamma) than buy-in of put option. On the contrary, a negative GEX means either there is more buy-in of put open interest than buy-in of call open interest or more sell-out of call open interest than sell-out of put open interest. In this way, if we observe extreme positive gamma exposure, it means the mass traders bet on the upside of the underlying asset. However, this may not be an already effective indicator for us to expect the future market movement. After all, traders use different time frames with varied aims (to hedge or to directionally bet). GEX needs to be further analysed in accordance with other option information such as strike price, expiration time and greek values. GEX is just an indicator telling us the major action of mass traders and how much position from the market markers is not yet hedged.

As we indicate, one major function of GEX is to imply current risk level for market makers. When a big GEX is observed in the market either in positive or negative value, it means market makers may face a considerate gamma exposure risk needs to be hedged. This is especially indicative when big GEX occurs near the expiration term or on the strike date. Since market makers have to play the opposite against the mass traders, market makers need to trade on the underlying market or take other measures before the strike date to offset their GEX risk. Otherwise, they would lose their spreads. Based on this analysis, we can deduce an approximate price range or key price level market makers would expect or be glad to see when the option price comes near the end strike date. In this way, we can construct a basic but effective option strategy using extreme GEX near term-to-expiration value to estimate risk level of market makers. Together with technical analysis or fundamental method, we may expect price movement with higher chance of winning aspect based on trading flow and option chain information.

02. Case study of recent market movement

An interesting case I observed recently was the price movement of TSLA on 21st of April. The basic setting and background of this story was a fundamental bullish view. From the the first quarter financial release at 17:30 pm 20th of April, the total revenue of TSLA grew 81% on an annual basis. On 21st of April, the market opened with gap high to 1090 in the first 15 minutes then fell down across the whole day. The fundamental bull seemed to be digested as soon as the market opened and then vanished. If any fundamental traders followed the news and traded instead, the market might be too late to join for them. Definitely some traders tend to apply a long-term strategy rather an intra-day scalping. That type of traders would not be our discussion scope. One biggest challenge for short-term fundamental traders is how to estimate the price distance of a fundamental driver. Even if we know which direction the market is going to move, when will it happen and how far the price action should we expect? Answers often come from technical analysis and trading flow information. With further technical analysis, we also noticed that from 8th to 20th April the price was approximately in a 975 to 1030 trading range. At the close of 20th, it fell at the bottom of the trading range. On a larger time frame, it might be situated in a pull-back area of downward trend but we didn’t know whether the market was a strong reversal or how far the pull-back could reach. Could it break through the trading range to upside or downside, if so and when? Based on all these analysis, we need further confirmation from other hints.

We further analysed the option chain information and found the following interesting fact:

Figure 1: GEX distribution of 22nd April expiration contract (statistics by 20th April)

Figure 2: GEX distribution of 22nd April expiration contract (statistics by 19th April)

Without further statistical analysis, intuitively we can already find the most positive GEX gathers at 1050 price level while the most negative GEX gathers at 950 price level on 20th April. On 19th April, the most positive GEX concentrated at 1050 to 1095 price range and the most negative GEX appeared at 950 level. Of course readers with further interest can explore more statistical ways of dealing with GEX distribution information and see how to come up with more information-concentrated results. Nonetheless, from basic GEX extreme value distribution we get the following information:

The most negative GEX risk and short position on stock market for market makers concentrate at 1050 to 1095 price range. As the voluntary sell-out party over large volume of long call, market makers would not expect stock price go up further than this price range at or near strike date. On the contrary, market makers would expect price at expiration can stay as possible below the price range for GEX risk level. In this way, market makers can spend less of the hedging cost used to offset the risk exposure of short position. Similarly, the most positive GEX risk collects at approximately 950 level. That means the market makers would not expect price drop further than the most negative GEX price level so that they can remain a relatively ideal risk level. Therefore, we estimate at a high chance the price would move to 950 to 1050 price range within two days left till strike date. Based on this intuition, we predict the future possible price movement range using option chain information. Individual traders can further construct own option strategies such as short strangle to estimate a reasonable price range in accordance with technical analysis and then play the trades.

03. Summary

In today’s option blog we shared the basic concept of gamma exposure and its practice in trading games. Through GEX analysis we may understand the position market makers take in the market and their expected action. We should make aware of the following key points using GEX to trade in the market:

The first is to figure out the position direction of market makers. We should understand market makers are taking long or short position currently so as to analyse their hedging direction.

The second point is to notice especially extreme GEX value near expiration term date. A extreme big value in GEX either being positive or negative near strike date would be more likely driving momentum impact in a short expected period. Since market makers are inclined to hedge before strike date, extreme GEX near the deadline would probably be a problem they need to solve as soon.

The third point is to estimate the price key point or price range market makers might watch out. We can deduce an approximate price level using GEX extreme value and further option chain information. Although market makers cannot control the market price movement, they can influence the market liquidity so as to indirectly influence the price market by controlling trade orders. Also, an obvious truth is that most market makers survive longer than individual traders. We can reasonably assume they have a less chance of losing compared with mass traders. Therefore, we may expect market makers will finally find a way to hedge their risk and push price level to their “ideal range”. Definitely there can be always other variables or black swan events that may drive market movement away from our expectation, however trading itself fundamentally is a probability game. All we aim is to adding our winning chance through option chain analysis, while on the flip-side risk management is always the prime winning point we should never neglect.

In this week’s option post we introduced GEX and the option trading strategies based on it. Hope my sharing can delight you and hope all the traders have fun in the market!