Dealer gamma is a crucial concept in options trading, representing the aggregate gamma position held by market makers, who facilitate trading by providing liquidity. Gamma, in options, measures the rate of change of an option's delta with respect to changes in the underlying asset's price. When market makers sell options to traders, they often become 'short gamma,' meaning they have a negative gamma exposure. This short gamma position necessitates dynamic hedging to maintain a delta-neutral portfolio. As the price of the underlying asset moves, market makers must buy or sell shares of the underlying asset to rebalance their delta, an action often referred to as 'gamma hedging.' If the underlying asset moves sharply, their delta changes rapidly, requiring more significant adjustments. For example, if the market maker is short gamma and the underlying stock price rises, their delta becomes more positive, so they would need to sell shares of the underlying to re-neutralize their position. Conversely, if the stock price falls, their delta becomes more negative, prompting them to buy shares. This continuous buying and selling by dealers in response to price movements is known as 'gamma-driven flow.' When there is a significant concentration of short gamma among dealers, their hedging activities can amplify price movements. A rising market will cause dealers to sell shares, potentially slowing down the rally, while a falling market will cause them to buy shares, potentially cushioning the decline. This is often called 'gamma unclenching' or 'gamma flattening the curve.' Conversely, if dealers are collectively long gamma, their hedging behavior would lead them to buy into rising markets and sell into falling markets, which can exacerbate trends rather than dampen them. The magnitude of this dealer gamma effect is particularly pronounced around strike prices where a large volume of options are soon to expire, as gamma values tend to peak for at-the-money options closer to expiration. Understanding dealer gamma is essential for comprehending short-term market dynamics and potential volatility shifts.
Market makers provide liquidity by continuously quoting buy and sell prices for options. Their primary role in relation to dealer gamma is to hedge their options inventory, often leading to a net short gamma position that requires them to dynamically adjust their underlying stock holdings.
Gamma hedging involves market makers buying or selling the underlying asset to maintain a delta-neutral portfolio as the price changes. This activity can either stabilize prices by counteracting trends or amplify them, depending on the aggregate dealer gamma position.
Dealer gamma is discussed with 'gamma squeezes' because when market makers are significantly short gamma and the underlying asset moves sharply, their rapid hedging (buying into rallies or selling into declines) can exacerbate existing price movements, creating a 'squeeze' on the market.
.png)