The Market’s Elusive Gamma Profile

“The Market’s Gamma Profile: Elusive” by Macro Risk Advisors

It would be nice if we actually understood positioning and mechanical buying/selling that results from price changes.

We are not even close.

For those seeking to better understand market risk, positioning is the holy grail. In this context, seeking insights on positioning can be summarized as asking “who has what on and in what size and what are the individual reaction functions to changes in price?”.

To a large degree, value investors and momentum investors have opposite reaction functions. The long and short vol trader do as well as one’s (long vol) re-hedging pursuits can be said to mute price changes, the other’s (short vol) said to amplify.

There is a lot of market dialogue around the market’s “gamma profile.” Certainly, a worthy conversation because we do know how gamma hedging works. It is mechanical.

But the pinpoint precision of estimates of the dollars of SPX that need to be either bought or sold as a function of the various systematic strategies in the market (options, vol control, etc.) is unreasonable, to put it kindly.

Here are 10 components of what we do not know (and really need to know) in order to get a closer estimate.

1. Bought Versus Sold. Can we measure and properly classify the trades as buys versus sells? Are put spreads and put “stupids” counted as the same trade?
2. SX5E, NKY, Kospi. There are other important underlyings that leave dealers with meaningful vol exposures. Greeks are often viewed on a global aggregated basis.
3. OTC Listed Look-a-likes. While some of these are reported to the SDR, the lion’s share are not. The BIS reports 3.4 trillion USD of notional outstanding, down from the peak, but still a real number.
4. Aged OTC trades. Remember that giant 5-year collar done with a pension fund 4 and a half years ago? It might now be live with regard to gamma exposure.
5. Light Exotics: The complex of variance swaps and other trades like PDOs and rate contingent puts have real greeks. No one has any idea how much is out there and where the trades are struck.
6. Listed VIX Options and Volatility ETPs. There is a huge market here that often goes unrecognized in the analysis of the market’s gamma profile.
7. Cross Asset Vol. Events that originate outside of the SPX can cause movement in the SPX. The market’s long or short exposure to vol in related asset classes matters.
8. Structure Products. This is the cornerstone of vol, skew and correlation exposure in dealer books across Europe and Asia. The market’s “vanna” profile that results from structures like auto-callables is substantial.
9. Relative Value. If the Street facilitated a long SX5E / short SPX vol trade for a client, how should we think about the hedging strategy pursued?
10. Alternative Risk Premia. These days, one can flip a switch to pay or receive carry in various formats (variance risk premium, currency risk premium, VIX systematic strategies). How can we incorporate these?

There’s a ton of work to do on this front.