January 4, 2023
 min read

The Rise of Option Trading

In contemporary equity markets, the popularity of options trading has risen substantially over the past few years.

In contemporary equity markets, the popularity of options trading has risen substantially over the past few years. The cause of this phenomenon can be alluded to a few reasons.


First and foremost, many investors are beginning to realize the flexibility of options and how they can be used to express virtually any market view. Whereas with stocks, you are either directionally betting on it to go up/down. With options, one can bet for the stock to go up/down, trade sideways, have a volatility implosion, volatility crush, and many other outcomes, all of which also incorporate the time/duration element. So wherewith stocks, you are trading a very binary/one-dimensional instrument, options are non-binary and multidimensional. In essence, options allow investors flexibility and freedom.


Moreover, in recent years, markets have been extremely volatile; the Covid crash and the subsequent V recovery, created an environment where hedging was needed and the use of leverage became very prominent – and naturally, options would thrive in this environment.


Traditionally, and as most of the academic literature follows, equity options derive their value from the underlying equity (stock). This is true in most market conditions, however, due to sheer increase in option volumes over the past few years, leverage became more prevalent than ever before, allowing sheer option market dynamics to take over, subjugating the underlying stocks to gamma effects (which were more exacerbated due to short squeezes in certain cases; think of the AMC/GME mania in January 2021). The result of all of this was an environment where not only did equity options derive their value from their underlying, but on a scale never before seen, they were now affecting the values of the underlying stocks. Another classic example of a stock that has seen much of its rise in value, apart of the meme-stonk mania, is TSLA. TSLA has been the beneficiary of many gamma induced rallies in recent years.


How does this all work you may ask? It’s quite simple.


Let’s say you buy an ATM call stock option on TSLA with a delta of about 0.50, an options dealer is selling you that stock option. Dealers typically maintain a delta-neutral book (they aren’t in the business to bet on stocks to go up/down, they are there to provide liquidity, naturally most books will be delta-neutral). This means that as soon the dealer sells you this call option, they will go out into the open market and buy 50 shares to ensure that their exposure on the trade is hedged. Now, just like delta, that call option will also have gamma. Gamma isn’t typically fully hedged and dealers use it as a forward-basis to see how much delta-hedging is needed.


Now imagine instead of only me buying that call option, all of a sudden there is an unprecedented amount of call option buying, on a scale not before seen or one which the dealers have failed to account for, and it’s also all occurring on weekly calls that are deep OTM (meaning gamma can accelerate very quickly, thereby also rapidly increasing delta and ultimately the EXTENT TO WHICH DEALERS HAVE TO HEDGE, this last bit is very important). All of a sudden, the dealers which are selling these calls have to buy excessive inventories of the underlying, often more than the extent they need to be delta-neutral, because they also need to manage their gamma exposures. To take things to an ever more extreme, now imagine all of this occurring in the context of a stock like GME, which had a very low float and a high short interest. Think of all the excessive short-dated call buying (it wasn’t just retail money as is often publicized, many institutions on Wall Stock part in the meme-stonk craze), the gamma induced rallies, all of which led to more short-covering, more call-buying, and more gamma induced rallies; a vicious cycle until finally dealers were able to stabilize the situation by charging an excessively high volatility premium which

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