As the season winds down I want to take some time to explain in very simple terms and without the usual option terminology how a basic "delta hedge" works and how it can cause markets to collapse.
Assume a situation with only one option dealer and a sole option trader, both with enough firepower to influence markets.
Take a look at the chart: September 2nd the trader decided to hedge against a decline of the S&P 500 and buys x amount of puts from the option dealer. The dealer would lose money if the market actually drops (he is short the put) and is therefore eliminating this risk by initially selling an amount x of S&P 500 futures. This is called the initial delta hedge.
Starting September 7th the market begins to actually decline and while the dealer is now losing money on it's short put position, he is also gaining money from it's short future position. All good!
However..as the market continues to drop faster a problem is emerging: Given the non-linear nature of options, the dealer is starting to lose increasingly more money on his short put for every point the market drops, but the value of his short future position continues to grow only in a linear fashion.
At a certain point the directional risk is getting out of hand, and the dealer is forced to re-adjust his original delta hedge by selling even more futures into an already weak environment, which causes the market to break and to collapse even faster.
The unraveling is now fully underway and the usual pundits proclaim armageddon, but what the bystander don't t realize is, that the dealer is now fully hedged again (at least for a moment) and stops selling, which causes volatility to decline and markets to stabilize again.
In a follow-up episode I will explain, how dealer positioning can cause markets switch fast from selling off hard to gaining explosively. I hope I was able to clear some things up.
Until then!
Assume a situation with only one option dealer and a sole option trader, both with enough firepower to influence markets.
Take a look at the chart: September 2nd the trader decided to hedge against a decline of the S&P 500 and buys x amount of puts from the option dealer. The dealer would lose money if the market actually drops (he is short the put) and is therefore eliminating this risk by initially selling an amount x of S&P 500 futures. This is called the initial delta hedge.
Starting September 7th the market begins to actually decline and while the dealer is now losing money on it's short put position, he is also gaining money from it's short future position. All good!
However..as the market continues to drop faster a problem is emerging: Given the non-linear nature of options, the dealer is starting to lose increasingly more money on his short put for every point the market drops, but the value of his short future position continues to grow only in a linear fashion.
At a certain point the directional risk is getting out of hand, and the dealer is forced to re-adjust his original delta hedge by selling even more futures into an already weak environment, which causes the market to break and to collapse even faster.
The unraveling is now fully underway and the usual pundits proclaim armageddon, but what the bystander don't t realize is, that the dealer is now fully hedged again (at least for a moment) and stops selling, which causes volatility to decline and markets to stabilize again.
In a follow-up episode I will explain, how dealer positioning can cause markets switch fast from selling off hard to gaining explosively. I hope I was able to clear some things up.
Until then!
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The information and publications are not meant to be, and do not constitute, financial, investment, trading, or other types of advice or recommendations supplied or endorsed by TradingView. Read more in the Terms of Use.
Disclaimer
The information and publications are not meant to be, and do not constitute, financial, investment, trading, or other types of advice or recommendations supplied or endorsed by TradingView. Read more in the Terms of Use.