Breaking News
0
Ad-Free Version. Upgrade your Investing.com experience. Save up to 40% More details

Gamma Flips And Regime Changes

By Erik LytikainenStock MarketsSep 06, 2020 04:18AM ET
www.investing.com/analysis/gamma-flips-and-regime-changes-200536377
Gamma Flips And Regime Changes
By Erik Lytikainen   |  Sep 06, 2020 04:18AM ET
Saved. See Saved Items.
This article has already been saved in your Saved Items
 

With option trading volume up substantially this year, there is an increasing need to understand gamma and related metrics.

One of the concepts market professionals often discuss is the concept of a “gamma flip.” Beware, however, there are differing definitions of what a gamma flip can be.

In our terminology, the gamma flip refers to a regime change.

No, not that kind of regime. Gamma is a financial concept, not a political one. A gamma flip refers to a transition of the markets from one volatility regime to another. In a lower volatility regime, investors can often rest while markets increase in value. In a higher volatility regime, the market can swing wildly, creating investor fear and anxiety.

Gamma Neutral Sets The Volatility Regime

Volatility regime change often occurs when the value of a stock or index falls below what we call the “Gamma Neutral” level. For instance, when the S&P 500 is higher than its Gamma Neutral level, volatility tends to be lower. When the value of the S&P is below Gamma Neutral, volatility increases.

We illustrate this concept in the scatterplot below. When the price of the S&P 500 is above Gamma Neutral (to the right of the bold line), the next day price change is often contained in a narrow range.

SPX Price Chart
SPX Price Chart

Conversely, when the S&P price is lower than Gamma Neutral (to the left of the line above), then the daily price changes in the S&P can swing wildly, both up and down.

When price crosses above or below the Gamma Neutral level, it often results in a regime change for stock volatility[1].

A chart of the S&P 500 since 2019 shows the higher and lower-risk regimes. With the stock market rising to new highs, we are currently in a lower risk regime.

SPX Gamma Neutral With Gamma Bands Chart
SPX Gamma Neutral With Gamma Bands Chart

when the market is below Gamma Neutral. Whether or not this theory is accurate is less material as the clear evidence of a change in volatility above and below the Gamma Neutral level. We don’t need to know “why” in order to act upon evidence.

Side Note (1)

Some market professionals suggest the reason for the “gamma flip” is due to the default behavior of options market makers. This theory purports that options market makers will hedge by buying the S&P when the market is above Gamma Neutral and that they sell the S&P when the market is below Gamma Neutral. Whether or not this theory is accurate is less material as the clear evidence of a change in volatility above and below the Gamma Neutral level. We don’t need to know “why” in order to act upon evidence.

Back-Testing Risk Regime Trading

We set out to construct a back-test that captures value from this principle of Gamma Neutral related regime change.

To do so, we follow a few simple rules to improve our risk-adjusted returns from 2007.

The model assumes a normal state is 100% long the S&P 500 (SPX). When the value of SPX falls below the Gamma Neutral level, the SPX allocation is reduced to 50%. We also created a risk boundary based upon the Gamma Neutral level, where we judge risk as extreme. In that instance, the model reduces the position to 0%. We also embedded other risk adjustments relating to the speed of any sell-off.

The chart below shows the value of the SPX, the Gamma Neutral level, and the risk boundary where the position is exited. It’s important to note that the position is purchased again in part or full as it climbs back above the risk boundary and Gamma Neutral.

SPX Gamma Neutral With Gamma Bands Chart
SPX Gamma Neutral With Gamma Bands Chart

We back-tested this strategy from 2007 to the present and realized an 80% increase in risk-adjusted returns (measured by the Sharpe ratio). The annual volatility of this approach, versus a long-only position, falls from 21% to 10%.

Band Gamma/SPX Returns
Band Gamma/SPX Returns

Final Thoughts

With more money flowing through options markets, options metrics have increasing importance in understanding the overall value and market direction.

There has been more media attention relating to gamma levels, but little material on translating it into actionable strategies. Our approach increases the risk-adjusted return by proactively reducing position size in relation to gamma levels.

Gamma Flips And Regime Changes
 

Related Articles

Tim Knight
DraftKings In A Very Dangerous Position By Tim Knight - May 07, 2021 3

This is a good real-life example of how charting can be very helpful in giving warnings that something is going wrong. Below is the chart of DraftKings Inc (NASDAQ:DKNG) without...

Gamma Flips And Regime Changes

Add a Comment

Comment Guidelines

We encourage you to use comments to engage with users, share your perspective and ask questions of authors and each other. However, in order to maintain the high level of discourse we’ve all come to value and expect, please keep the following criteria in mind: 

  • Enrich the conversation
  • Stay focused and on track. Only post material that’s relevant to the topic being discussed.
  • Be respectful. Even negative opinions can be framed positively and diplomatically.
  •  Use standard writing style. Include punctuation and upper and lower cases.
  • NOTE: Spam and/or promotional messages and links within a comment will be removed
  • Avoid profanity, slander or personal attacks directed at an author or another user.
  • Don’t Monopolize the Conversation. We appreciate passion and conviction, but we also believe strongly in giving everyone a chance to air their thoughts. Therefore, in addition to civil interaction, we expect commenters to offer their opinions succinctly and thoughtfully, but not so repeatedly that others are annoyed or offended. If we receive complaints about individuals who take over a thread or forum, we reserve the right to ban them from the site, without recourse.
  • Only English comments will be allowed.

Perpetrators of spam or abuse will be deleted from the site and prohibited from future registration at Investing.com’s discretion.

Write your thoughts here
 
Are you sure you want to delete this chart?
 
Post
Post also to:
 
Replace the attached chart with a new chart ?
1000
Your ability to comment is currently suspended due to negative user reports. Your status will be reviewed by our moderators.
Please wait a minute before you try to comment again.
Thanks for your comment. Please note that all comments are pending until approved by our moderators. It may therefore take some time before it appears on our website.
 
Are you sure you want to delete this chart?
 
Post
 
Replace the attached chart with a new chart ?
1000
Your ability to comment is currently suspended due to negative user reports. Your status will be reviewed by our moderators.
Please wait a minute before you try to comment again.
Add Chart to Comment
Confirm Block

Are you sure you want to block %USER_NAME%?

By doing so, you and %USER_NAME% will not be able to see any of each other's Investing.com's posts.

%USER_NAME% was successfully added to your Block List

Since you’ve just unblocked this person, you must wait 48 hours before renewing the block.

Report this comment

I feel that this comment is:

Comment flagged

Thank You!

Your report has been sent to our moderators for review
Disclaimer: Fusion Media would like to remind you that the data contained in this website is not necessarily real-time nor accurate. All CFDs (stocks, indexes, futures) and Forex prices are not provided by exchanges but rather by market makers, and so prices may not be accurate and may differ from the actual market price, meaning prices are indicative and not appropriate for trading purposes. Therefore Fusion Media doesn`t bear any responsibility for any trading losses you might incur as a result of using this data.

Fusion Media or anyone involved with Fusion Media will not accept any liability for loss or damage as a result of reliance on the information including data, quotes, charts and buy/sell signals contained within this website. Please be fully informed regarding the risks and costs associated with trading the financial markets, it is one of the riskiest investment forms possible.
Continue with Google
or
Sign up with Email