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Plug in your stock idea to find options trades offering a potentially better ROI. Learn more about the OptionFinder QUOTES Get Quotes QuotesMy Recent Quotes Get Quotes Enter a stock ticker symbol above to find charts, news, and analysis. This box will populate with tickers you recently viewed by using the "Get Quotes" search box at the top of the page. MARKETS VIX 23.47 -1.16 (-4.94%) VIXDowNasdaqS&P 500 VIX 23.47 -1.16 -4.94% Dow (DJX) 104.25 +1.03 +1.00% Nasdaq (NDX) 1875.38 +12.28 +0.66% S&P 500 (SPX) 1102.66 +8.99 +0.82% CLOSE home > Analysis>Buy and Trade The Gamma Effect on Volatility When option market makers are net long options, stocks are tame by Kevin Cook in Buy and Trade February 12, 2010 - 10:46 am EST Comments (0) Related Symbols: SPX, VIX XWelcome to the Options News Network, where we offer trading news, analysis, and ideas. Want to learn more about options? Check out our Education page to get started.We’ve seen some fear and volatility in the market lately, but it always seems to subside and I wanted to explain one dynamic of this as it relates to options markets. What I’m going to describe is how the inherently “neutral” positions of option market makers help drive volatility even lower when institutional buy-side investors want to sell options. You’ve no doubt noticed how relatively quiet the broad market has been, with the S&P 500 Index (SPX) sticking either side of 1,100 for 2.5 months—just like I predicted in mid-November for both fundamental and technical reasons. But even I’m surprised it’s been sooo “sticky” at 1,100. The chart below shows the relative performance of the index vs. the CBOE Market Volatility Index (VIX) for the past six months, with SPX the black line and VIX the blue-green. On a relative % basis, the swings in the VIX look dramatic, while the stock market hovers around a 5% gain for six months. And there is another interesting force at work here that most stock investors aren’t familiar with. Just as high volatility begets higher volatility in a rapidly declining market, so too it can work in the opposite direction and it has to do with the natural behavior of option market makers when buy-side institutional investors tend to be premium sellers. Delta-Neutrality Encourages Gamma Scalping As you probably know, option market makers try to trade delta-neutral as much as they can, preferring to trade volatility instead of having directional risk. This means that when investors sell them puts, they have to buy stock to hedge. When the market goes up, market makers adjust their newly increased delta by selling stock. Conversely, when investors sell them calls, market makers sell stock to hedge and when the market drops and their delta position subsequently falls, they buy stock to adjust. This process tends to keep stocks in an increasingly narrow range. Why do option market makers’ positions gain (lose) delta when the market rises (falls) just because they are long options? It has to do with the relationship of delta and gamma. As an underlying market moves higher, all option deltas move higher, with calls becoming more in-the-money (ITM) and puts moving further away toward zero. As an underlying market moves lower, all option deltas move lower, with puts becoming more ITM and calls moving further away toward zero. And this delta build can happen at a faster rate because of the stochastic nature of gamma. So option market makers get to take advantage of this when they are long options (thus, long gamma)—they get to sell stock they are long at higher levels, and buy stock they are short at lower levels. Option market makers can actually make a significant portion of their profits from “gamma scalping,” as this is called. To learn more about delta and gamma, see my awesome education articles: Delta and Gamma: How Options Move With Stock Gamma: The Gears of Options Leverage This cycle where “lower vol begets lower vol” can persist for some time, until investors become bigger buyers of options. This may happen soon enough if we get a spike down in the market on fear, which causes a scramble for put protection, and a resulting bounce, which sees a rush for calls. But even then, there is relatively little fear in the market considering the problems in the Eurozone with sovereign debt risk, and after this equity correction is over (see my Correction in Progress, Proceed with Caution piece), we should continue to see the S&P march higher while the VIX slips back below 20 in 2010 and the calm resumes. http://www.onn.tv/buy-and-trade/gamma-the-gears-of-options-leverage/More in Buy and Trade Previously AIG a Buy Here? 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