Article

Gamma and its Importance to the FX Trader

What is gamma?

An option?s price changes with fluctuations in several factors such as spot price, volatility, interest rates and time.  Delta is a measure of the change in option premium with respect to a change in the underlying, or spot, price.  Gamma represents the change in delta for a given change in the spot rate.

In trading terms, players become long gamma when they buy standard puts or calls, and short gamma when they sell them.  When commentators speak of the entire market being long or short gamma, they usually are referring to market-makers in the interbank market.

How market makers view gamma

Let?s consider how market makers view gamma. Generally, options market makers seek to be delta-neutral?that is, they want to hedge their portfolios against movement in the underlying spot rate.  The amount by which their delta, or hedge ratio, changes is known as gamma.

Say a trader is long gamma, meaning that she has bought some standard vanilla options. Assume they are USD/JPY options.  If we further assume that the delta position of these options is $10 million at USD/JPY 107, she will need to sell $10 million USD/JPY at 107 in order to hedge and be fully insulated against spot movement.

If USD/JPY rises to 108, she will need to sell another $10 million, this time at 108, as the total delta position becomes $20 million.  What happens if USD/JPY goes back to 107?  The delta position goes back to $10 million, as before.  Because she is now short $20 million, the trader will need to buy back $10 million at 107.  The net effect then is that she makes a 100-pip profit, selling and 108 and buying at 107.

Therefore, when traders are long gamma, they are continually buying low and selling high, or vice-versa, in order to hedge.  When the spot market is very volatile, traders will be earning a lot of profits through their hedging activity.  But these profits are not free, as they have paid a premium to own the options.  In theory, the amount one makes from delta hedging should exactly offset the premium.  Whether or not this is the case depends on the actual volatility of the spot rate.

The reverse is true when a trader has sold options.  As she is short gamma, in order to hedge she must continually buy high and sell low?thus she loses money on her hedges, in theory the exact same amount that she earns in option premium through her sales.

Why is gamma important for spot traders?

But what relevance does all this have for regular spot traders?  The answer is that spot movement is increasingly driven by what goes on in the options market.  When the market is long gamma, market-makers as a whole will be buying spot when it rises and selling spot when the exchange rate falls.  This behavior generally can keep the spot rate in a relatively tight range.

When the market is short gamma, however, the spot rate can be prone to wide swings as players are either continually selling when prices fall, or buying when prices rise.  A market that is short gamma will exacerbate price movement through its hedging activity. Thus:

  • Market-makers long gamma: Spot generally will trade in a tighter range
  • Market-makers short gamma: Spot can be prone to wide swings

Kathy Lien is the Chief Currency Strategist at Forex Capital Markets. Kathy is responsible for providing research and analysis for DailyFX, including technical and fundamental research reports, market commentaries and trading strategies. A seasoned FX analyst and trader, prior to joining FXCM, Kathy was an Associate at JPMorgan Chase where she worked in Cross Markets and Foreign Exchange Trading. Kathy has vast experience within the interbank market using both technical and fundamental analysis to trade FX spot and options. She also has experience trading a number of products outside of FX, including interest rate derivatives, bonds, equities, and futures. She has a Bachelors degree in Finance from New York University. Kathy has written for Stocks and Commodities, CBS Market Watch, ActiveTrader, Futures and SFO Magazine. She has taught seminars across the country and is frequently quoted on Bloomberg and Reuters with appearances on both CNBC and CBS. She has also hosted trader chats on EliteTrader, eSignal, and FXStreet, sharing her expertise in both technical and fundamental analysis.

Dec 5, 2004
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Kombatshe
#4
One, regular spot traders dont know the gamma from the chart - u need to have the option information mapped out to the chart like a field landmine chart - which I doubt anybody has unless u're inventorizing your positions as a bank or a large broker. Two, u cant act on information that u dont have. Three, u know the range AFTER it has formed. Therefore this is certainly not helping much for 'regular spot traders'. I dont know why people still believe in these things.
 

rog1111

Active member
Jan 30, 2004
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#5
I have done some similar research in the past (1999) for many commodities, as part of an effort to improve upon the standard call/put ratio. After all what use knowing how many calls & puts there are unless you know WHERE they are. Since most options are written by pros, who will also be very active in the underlying, you can begin to see the logic in it.

Even today, and certainly not back then, I don't think that the options open positions in currencies are substantial enough to have a large bearing on their price, you can partly confirm this by comparison of the weekly futures only COT reports vs futures & options combined, although these will not be the only currency options out there.

IMO there are other commodities for which this is well worth a look, if you can get the data, anything with decent options OI, and a good ratio of options : futures volume

rog1111
 

rog1111

Active member
Jan 30, 2004
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#6
GJ thanks for the reply, I accept your comments, and anything is possible, but I doubt whether theres anyone here that can confirm how many otc options are out there ? All good interesting stuff.

regards
rog1111

GammaJammer said:
Rog - what you've written is a little inaccurate. The volume of otc options out there absolutely dwarfs that of exchange traded ones, by several orders of magnitude. That's why this stuff has a real bearing on the activity of the cash spot market. Just because it isn't quantifiable, doesn't mean it doesn't have an effect.

And that's what this article was trying to get at - all you can have is a general understanding of the way it works, and add that to your arsenal of knowledge about the market in which you are trading. Just like knowing that fixing trades have an effect, but not being able to guarantee that they will affect a certain currency in a certain way on a given day.

GJ
 
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alexander

Active member
Mar 19, 2005
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#8
The two conclusions of the article are:

Market-makers long gamma: Spot generally will trade in a tighter range
Market-makers short gamma: Spot can be prone to wide swings


But these cannot be general rules or conclusions. The FX market is not affected only by the net position of option market makers. It is also affected (mainly) by macroeconomic fundamentals. It is not unusual to have market-makers long gamma (an expression I would no use by the way because traders are long/short underline assets, not some mathematical measure of those assets) and meanwhile have wild swings or trends or both in underline exchange pairs due to either significant commercial money flow or surprising news or maybe both

Then, the article does not consider how strike prices (in or out-of-the money) of market maker positions affect those conclusions. Generally speaking, those conclusions should be correct only under specific conditions, but limited in nature, like for instance when there are no news to affect market prices and market makers option strike prices are in-the-money, otherwise things get much more complicated and not as easy as the articles portrays them to be. Remember , market makers must take some risk to make more money and always do, hence and examples of firms that have lost a lot of money in FX trading.

I mean, it boils down to this: even if you know whether market makers are long or short gamma can you arbitrage based on this knowledge. Absolutely not. This knowledge is useless as far as making a sure profit.

Alex
 
Aug 11, 2003
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#9
It may be of little importance for the average retailer when it comes to making trading decisions but for me, understanding your market of choice like your own child, is vital and understanding the effect of options players is another part of the jigsaw and thus, helps to understand the market behaviour as a whole.
 

jacinto

Well-known member
Oct 7, 2005
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#10
mmm, well cool, but where can i know if the market makers are long or short gamma on FX? otherwise it is just theoretical knowledge that is nice to have.
 

alexander

Active member
Mar 19, 2005
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#11
mmm, well cool, but where can i know if the market makers are long or short gamma on FX? otherwise it is just theoretical knowledge that is nice to have.
Good point! You will never know that. That is information good for theoretical MBA courses but in practice impossible to get.

Alex
 
Jul 19, 2007
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#12
As a retail FX trader, one will never really know whats going on in the interbank spot or option markets...

However...

it IS possible to find information about Exchange traded FX options. Assuming that there are at least some Bank desks using these instruments, and assuming that the IB desks know whats going on, can the retail trader "extrapolate" this info onto the OTC FX option market?

I mean the Exchange traded option info is available, so there must be some use for it, right? If only to help guage (?) the sentiment of the OTC market?

Oliver
 
Jul 19, 2007
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#13
aaahh well...

it seems funny to me that with the dissemination of information that the internet allows, I am still making (albeit paper) trades on such original insight as "when the yellow line touches the blue line, and the pink line isnt near the green one".

Surely there's a better way...

Thank you GJ for your help and prompt response - on both counts.

Oliver
 
Nov 25, 2010
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#15
Where is the info....

I am very interested in the concepts of this article. Where do you find the information relating to the Market Maker's gamma position? I have searched the internet for several hours and can find no place that gives that particular piece of information. TY R
 
Nov 25, 2010
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#16
After reading all the posts to this article it appears that considering market-maker's gamma position is at best an intellectual prsuit with no practical knowledge. Perhaps someone out there with experience trading options knows a way to extrapolate usable info using open interest or the rise and fall of IV, or ???