How Options Delta Hedging Can Feed Back Into Underlying Prices
Summary
The document asks whether large options positions can make the underlying’s price respond to derivatives activity, especially when dealers must hedge positions with high gamma. It describes the proposed feedback: negative gamma hedgers may buy into sharp rises, while positive gamma hedgers may trade in the opposite direction during declines, potentially affecting volatility and option smiles.
The response points readers to work on optimal options trading and market price formation, including analysis of a saw-tooth price pattern, and adds research on stock pinning near option strikes at expiry. These references offer possible mechanisms and literature leads rather than a measured conclusion about when options activity dominates the underlying. The discussion is brief and supplies no quantitative evidence, model, or conditions for the effect. It also distinguishes pinning, which it characterizes as potentially strategic price pressure near a strike, from delta-hedging feedback more generally.
Key ideas
- Options open interest can be large relative to the underlying’s value, raising questions about hedging effects on prices.
- Negative gamma hedging may reinforce sharp rises through buying in the underlying.
- Positive gamma hedging may cause traders to trade against large declines.
- Research on price formation and strike pinning provides relevant starting points, but the document gives no quantitative test.
Tags
Full text
# When does the underlying become the derivative? # When does the underlying become the derivative? Since options contracts are created by open interest in the contract, it is conceivable that the notional of the total options contracts can exceed the value of the underlying. If that happens, does the underlying become the derivative of the options? This is more than just a theoretical question. I have started to see in some markets with large options open interest where the delta hedging of the options contracts start to impact the volatility of the underlying--particularly in high gamma/convexity contracts. Those that have negative gamma end up having to buy the underlying in large up moves and exacerbate the volatility on the upside. Conversely those with positive gamma do the opposite in large down moves. In these markets, would we see larger smiles? Have there been any studies of this feedback phenomenon? Any literature recommendations would be appreciated. ## Answer by lehalle (score 4, accepted) https://quant.stackexchange.com/a/70541 To illustrate his paper on optimal trading for options, Robert Almgren issued this nice pdf with interesting feedback effects. He reproduces this graphs from What does the saw-tooth pattern on US markets on 19 July 2012 tell us about the price formation process by L et al.: This interesting effect has to be complemented with pinning as illustrated by A market-induced mechanism for stock pinning, by Avellaneda and Lipkin in 2003. Pinning is more "price manipulation" (when it can be interesting for big participants to push the price above or below the strike at expiry) and nowadays regulators are looking carefully at it.
Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.