Gamma Play on a Rigged Field
Originally published in TDV Jan 2021 issue and edited for clarity
I'm going to analyze the GameStop saga by looking at the brokers' moves on Thursday and Friday and through the lens of the option writers - the dealers who originate stock options by underwriting them.
Writing options is a complex field, much different from purchasing options to speculate on price moves. Because option writers take on theoretically unlimited risk, they need to hedge their exposure so adverse moves don't blow them up. Typically, they do not make directional bets, but try to manage their delta and gamma by hedging the exposure they take on while underwriting options. Sometimes, they do blow up spectacularly by holding directional exposure, like on those trades where option buyers like us make 1000%, which in turn at a minimum cautions other option writers to be more careful about their exposures.
The trading restrictions on Thursday / Friday were meant to benefit the option writers too. I'll explain how.
To explain how option writers hedge risk, let's take the example of Chamath Palihapitiya, billionaire tech investor who tweeted that he had bought 50 call options on GME with a strike price of $115, expiring February 19th. Let's say I sold those options and pocketed $125,000 in option premium, which is roughly the amount quoted on the trade in a research blog I saw. Since each option contract is for 100 shares, if GME stock rises above $115, I am now liable to deliver 5000 shares of GME if the option is exercised. Or alternatively, I could just cover my position and pay the difference between the market price and $115. That works out to $5,000 for every $1 it rises.
When GME hit a peak value of $483, my net notional loss was at least $1,715,000 [($483-$115) times 5000 shares minus $125,000 in premium received]. It's an easy way to go broke, and also, it is the reason option writers don't like to make directional bets. It is also the reason we don’t
recommend writing options in our newsletter.
The easiest way to hedge the risk is by owning the shares that you write the options on.
That way you are just giving up your upside. This is called a covered write, or being “delta neutral”.
Naked writing is allowed but requires a lot of margin, often excessive for the average person.
How else to hedge this risk? Today, I'll explain one popular method by hedge fund managers often too smart for their own good: it’s called, surprise: delta hedging. The Delta is a measure of change. In this case, it is a measure of the expected change in the price of the option for every $1 change in the stock at any given level relative to its strike price. I'm simplifying here, but in this example, the delta would be 0 if GME were trading at its 52-week low of $2.57, moving closer to 1 as the stock rose, and 1 if GME is at or already well above $115.
When Chamath bought his options, GME was trading at $89.5, and the options were out of the money, so they had no intrinsic value. Let's assume for the sake of a thought exercise that the delta was 0.1 at that point.
As a delta hedger, I would then have to buy just 500 shares at $89.5 instead of the full 5000 shares.
As GME rose another 28% to reach $115 the call options for that moment became “at-the-money”, and the delta increased to 0.5, and then 1.0 as the shares crossed over the strike. In other words, the expected rate of change was increasing until it hit the steepest slope at 1. This then declines again as the option trades deeper into the money, i.e., if GME’s shares keep rising past the strike price. What this does, however, besides making a lot of money for the call buyers in a short period of time is that it forces delta hedgers to buy more shares. In other words, although the stock had a record short interest in equity relative to its daily trading volumes, this was exacerbated by the number of delta hedgers caught off guard at increasing strike plateaus.
As long as the writer buys the other 90% of the shares to go delta-neutral below about $150 in this example he is probably okay, at least break even. And obviously there are more sophisticated versions of this strategy.
But they all have one thing in common: at some point, if you want to earn a reasonable return, somewhere down the line you are unhedged. In the case of GME, a lot of the volume was in call options, which meant that any of the option writers who didn’t cover their option shorts would on net end up with huge long positions in the stock that they would need to sell when the options expire.
When retail investors went into a call buying frenzy, call option writers were part of the feeding frenzy contributing to the stock's meteoric rise. This buying was an additional source of demand to the short covering we saw in the stock. Given how sharp the move was, I suspect quite a few dealers were caught short gamma (didn't manage to buy enough shares to hedge the call options they sold), and needed the Thursday respite to avoid going broke.
Friday was an option expiry day. As option contracts got closed out, the option writers needed to unwind their positions in the underlying stocks. For that, they needed orderly markets where they could trade.
Call option sellers needed to sell their shares to unwind their hedges. And the brokers conveniently removed the trading restrictions to facilitate that, after helping the short sellers drive down prices on Thursday.
They also prodded early closing of contracts through more subtle means.
For months, the cabal helped facilitate naked short selling, which is the only explanation for how short interest can be 138% of float away. Then on Thursday, they halted retail trading to help Citadel, Point72, and Melvin Capital off, which hurt the retail stockholders. Then on Friday, they ostensibly had a change of heart and allowed trading... or they orchestrated another coup so their option writing buddies wouldn't blow up.
I leave it to you to decide.
P.S. The current option open interest is still extraordinarily high at 1.85 million contracts, equivalent of 185 million shares, or nearly 4x the float. The stock can continue to exhibit violent moves until the situation is resolved. Stay vigilant if you're trading any of the WSB stocks!