Authored by Erik Lytikainen via RealInvestmentAdvice.com,
2020 has been quite a year for the stock and options markets. We have witnessed a gut-wrenching roller coaster ride from highs to lows and back to highs. The volumes of both stock and options trading have ballooned as discount brokers offer zero commission trading.
What few seem to realize is that the proliferation of options trading has created a new market dynamic. This dynamic can create feedback loops that could generate significant volatility. If we compare a feedback loop to a snowball rolling downhill, one can view the recent spike in options trading as a snowfall leading to a potential avalanche.
To make our case, we provide a simplified option hedging example to show how this practice can affect order flow in the underlying markets. Specifically, options delta hedging can lead to amplified upward and downward price pressure. With options trading at record volumes, one should not overlook this point.
Options Hedging Example
To illustrate the effects of delta hedging, let’s consider an example. A bank or broker that writes options will usually construct and manage a delta neutral portfolio to manage this risk. For this example, we consider a delta hedger in SPY that ended a recent trading day with a delta-neutral hedged position. We show this in the first table below.
The closing price of SPY is $321/share. The market participant sold 100 call options at the $340/share strike price, with options expiration 28 days away. To hedge this position close to delta-neutral, the participant sold 57 puts at a strike price of $300/share. There are many ways to hedge...