Dealer positioning and hedging

The lesson in plain words

The same lesson as the slides above, written out in full.

1. The desk that stays flat

Welcome. Today we look at how the large options market makers, the dealers, manage the risk they take on when they buy and sell contracts with the rest of the market. The key idea is that they usually do not want a directional bet, so they trade the underlying stock to offset the delta of their options book. Once you see how that hedging works, a lot of odd intraday price behaviour starts to make sense.

• Dealers are the market makers who take the other side of options trades
• They usually do not want a directional bet on the stock
• They offset risk by trading the underlying against their options
• The goal is a book that is roughly delta-neutral
• Their hedging can quietly move the tape

A quick note: This is financial education only, not financial advice. The numbers here are illustrative, and nothing on this page is a recommendation to buy or sell any security.

2. What delta-neutral means

Delta measures how much an option's value moves when the underlying moves one point. A dealer who ends up holding options with, say, positive delta can offset it by selling shares, so the two cancel out. When the net delta sits near zero, the desk aims to make its money from spreads and fees rather than from the direction of the stock.

• Delta is how much an option moves per one point in the stock
• A long call carries positive delta, a long put negative
• Holding shares against options can offset that delta
• When the total sits near zero the book is delta-neutral
• The desk then earns from the spread, not the direction

3. Why the hedge keeps moving

Here is the twist. Delta is not fixed. As the underlying price moves, the delta of the options changes, so a book that was neutral this morning drifts out of balance. To get back to neutral the dealer keeps buying or selling shares as price moves, and that steady stream of hedging trades is the part that touches the tape.

• Delta is not fixed, it shifts as price moves, and that shift is gamma
• A neutral book drifts out of balance when the stock moves
• To restore neutral the dealer rehedges with more shares
• So the hedge is adjusted again and again through the day
• This constant rehedging is what reaches the tape

4. When hedging calms or feeds a move

Which way those hedges push depends on the sign of the dealer's gamma. When dealers are net long gamma, they sell into rallies and buy into dips, which tends to calm the tape. When they are net short gamma, they do the opposite, buying strength and selling weakness, which can stretch a move further. This is a public market-structure idea, not a trade call we sell or act on.

• The direction of the push depends on the sign of dealer gamma
• Long gamma: sell into rallies, buy into dips, moves tend to fade
• Short gamma: buy into rallies, sell into dips, moves tend to grow
• So the same hedging can either dampen or amplify a move
• This is a public market-structure effect, understood as concept only