Delta Hedging: How Options Traders Actually Influence Share Prices

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In this episode, we look at delta hedging by market makers, and how this leads to markets actually being moved by extraordinary speculative option trading. While it obviously isn't the only reason prices move, delta hedging explains how derivatives can actually impact the price of the underlying.

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I am not a CPA, attorney, or licensed financial advisor and the information in these videos shall not be construed as tax, legal, or financial advice from a qualified perspective. Linked items may create a financial benefit for Heresy Financial.

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I know this video is old, but one thing to mention....market makers do not "wait" for 2 party matching, they make the market by quoting the spread prices only, so yes, they create the book as well. There might be midpoint trades that the market maker and HFTs might pick up if they choose to, but that's a separate issue, they don't create the market purely because they create volume, that's just wrong....the volume will come regardless, they just quote the prices by creating the limit orders. Usually when one side gets hit, they move the needle toward that side...so if more buyers soak up the ask quote, the market maker will move the needle up and produce a new bid/ask at a higher price. They only need to be neutral at the end of the day, this is why you may see huge swings at "last call" (end of day) as neutrality comes into play, but it isn't all the time....computer systems are very advanced and usually will dynamically update the lot size in order to relay the needle movement required to remain neutral throughout the day.

As for the options, they hedge not only delta but in some cases gamma....however, again, they neutralize near last call. They will be buying and selling all sorts of options and stock, and each needle and spread is specific for each derivative. As before, it is linked with the dynamic system to change lot sizes within the underlying range at current spot to account for any need for balancing.

If the stock has a runaway situation, where one side is hit too hard of volume, the market maker may start reducing the spring tension on the lots, allowing for even more acceleration....the reason for this is because the market maker is attempting, through math alone, to find a balancing point where supply and demand are fighting each other. The only time the market maker human might get involved is for news events, they may specifically move the needle and override any of the system to start it off at a new position (this is how you get gaps, mostly)....or they could reduce the tension to let the stock rise or fall quickly on news (for intraday jumps).

In some situations, market makers might drop tension to near zero and let the stock bounce around like crazy, with wildly high option volatility prices....like GME and AMC during that whole debacle. A lot of people were selling CCs against their overinflated prices and MMs were going nuts driving down the prices on their short held positions to hedge, all while twitter was in a roar over "corruption in the markets" when they were doing it to themselves.

Lastly....you said there's more buying of Calls means upward sentiment and Puts downward, this is somewhat true, but is not the whole story. You have to first know whether or not the buys were against the MMs or not...having high bid volume on Puts is just as upward sentiment as Call ask volume. You can't just go on Call/Put volume alone, it has to be specifically on the edges for sentiment.

sabriath

Joe always explains markets in a way that's easy to understand and internalize

NJoe

Delta Heading. This was a great video. Need to look more into trading to understand what’s going on.

CaseyBurnsInvesting

This is great! Nice explanation on what’s contributing to markets that is not often talked about

OnTheGreen

So Joe, can you please give us a commentary on where you see the price of gold and silver heading over the month of September heading into the end of the year! Thanks!

petervella

Is the delta cumulative amongst all the trades the mm has open? Is that how they don't have to buy the full amount of shares to hedge zero? In other words, if they sell a call for 100 shares, I would think they would have buy 100 shares to hedge but instead I keep seeing that they may only have to buy 60 shares? How does that equal zero sum to stay neutral?

Sorry if confusing.

russjamison

Posting this on ST and WSB from 12.07 .. Good video!

bcsi

I know this is an old video, but I'm curious about your thoughts about what does the dealer do if someone sold a condor or strangle, assuming they cannot get someone to buy them out of this position? They are technically neutral, but losing money if the market stays flat.

veggiehamm

Great video! This dynamic of the market is fascinating. There's a lot of insight to be gained from understanding market mechanics. With all brokers going zero commissions, we're seeing an enormous record of retail traders in the market and historically unprecedented options buying. MM Delta hedging has added a 6th gear to the tech meltup - 40% of Nasdaq's August rally was purely due to MM delta hedging! People talk about big money driving the market a lot, they set the bottom in March but August was a great example of massive amounts of retail fomo actually driving the market

DavidIzzy

Nevermind my other question. I see the option shares move at different paces then the underlying stock. Your 50% scenario (delta hedging) that you I'm starting to get it.

russjamison

Excellent, I wanted to know more about this.

John-qtvt

Exactly what I needed to understand! Thanks!

giveitup

Great video. Been waiting for discount to buy your options foundations course.

sohailsheikh

that was an amazing explanation! thank you :)

mariusmeiners

Thanks for the insight into how that works ! Are you going to do an advanced option course? I know you mentioned it at some point.... Thanks again.

wagvice