Delta Hedging – Why the Stock Market Falls Fast

Will there be a stock market crash soon?
Kevin Wenke

Kevin Wenke

CFP | CLU | Investing | Insurances | Taxes

Have you ever wondered why, when the stock market falls, it seems to fall very quickly and hard? You may believe it is because investors are their selling stocks to “get out” when they get scared the market could keep falling. That may be true but that is

Will there be a stock market crash soon?

only part of the answer. The rapid decline in stocks value can also be attributed to the investment industry selling stocks it doesn’t own (short selling) as a strategy to protect themselves from market movements and that is a strategy called “delta hedging” which is an insulation from any change (delta) in price of a security.

What Are Investment "Broker-Dealers" And Why Do They Delta Hedge?

To understand delta hedging, we first need to understand what “broker-dealers” are. Broker-dealers are financial companies that help investors buy and sell stocks, bonds, and other investments, like derivatives. 

In many ways, they are like used car dealers who help retail buyers and sellers move vehicles in the secondary market.

Just as used car dealers don’t aim to make money on the price movement of their inventory, security broker-dealers aren’t looking to profit from the fluctuations of stock prices. Instead, both types of dealers focus on earning commissions by matching buyers with sellers.

Security broker-dealers strive to be “the house” and make money regardless of which direction the stock market moves. A great example of this can be found in the movie “Trading Places.” In the film, Eddie Murphy’s character, Billy Ray Valentine, sits with the Duke Brothers as they explain how their company, “Duke and Duke,” makes money. Valentine quickly realizes that they’re just like bookies, making a profit no matter the outcome of the stock market.

Security broker-dealers not only facilitate transactions between buyers and sellers but also occasionally buy and sell securities themselves. They hold these securities in their own inventory until they can find another party to complete the transaction. This practice is especially common with derivative contracts, like options, where demand from investors might be higher for one position than there are investors willing to grant such rights.

For example, let’s say many investors want the right to sell a security in the future at a predetermined price (they buy “put options”), but there aren’t enough investors willing to grant this right (investors who will sell “put options”.) In this case, broker-dealers step in to fill the void and meet the demand. They sell the investors put contracts. However, buy selling them this contract, it leaves the broker-dealer exposed, as they are now contractually obligated to fulfill these contracts.

Since broker-dealers don’t want to make or lose money on the contract’s performance and only want to collect commissions, they really don’t care what the stock market does. However, if it starts to move in a way that could cause them to lose money with their positions, they using hedging strategies to insulate themselves from changes in the underlying security’s movement – EVEN IF THEIR ACTIONS CAUSES THE MARKETS TO MOVE EVEN MORE! Delta hedging is one of the strategies.

By delta hedging their positions, they can minimize their risk exposure and ensure they continue to profit from commissions, regardless of how the market moves. This practice is crucial to maintaining their role as a neutral middleman between buyers and sellers, much like how the Duke Brothers aimed to operate in the movie “Trading Places.” Remember, they want to make money regardless of whether you make money or lose money…

The Derivative Market and Its Size Compared to the Stock Market

Derivatives are special types of investments that get their value from other things, like stocks, bonds, or even the weather! There are many kinds of derivatives, but we will focus on two types called “options” and “futures.”

The derivative market is very big. In fact, it is 7-8x bigger than the stock market! This means that when something happens in the derivative market, it can have a big effect on the stock market. If you don’t consider this dynamic, you aren’t playing in the same game as the financial industry and are leaving yourself exposed to loses yourself.

The Mechanics of How Delta Hedging Works

Now that we know about the derivative market and broker-dealers let’s learn about delta hedging. Delta hedging has to do with “options,” which are a type of derivative. There are two main types of options: “call options” and “put options.”

A call option gives the buyer the right to buy a stock at a certain price by a certain date. A put option gives the buyer the right to sell a stock at a certain price by a certain date. These options have something called “delta,” which tells us how much the price of the option changes when the price of the stock changes.

For example, if a call option has a delta of 0.5, it means that the price of the option will go up by 50 cents if the price of the stock goes up by $1. If the price of the stock goes down by $1, the price of the option will go down by 50 cents.

Broker-dealers use delta hedging to make sure they don’t lose money when the stock market goes down. They do this by buying and selling stocks in a way that balances out their risk vs the option contracts they are responsible for. Let’s look at an example:

Imagine a broker-dealer selling a put option to someone, granting that person the right to sell a stock at a predetermined price. If the stock market goes down below the contracted price (known as the “strike price”), the person who bought the call option will own something that has intrinsic value and, if the price stays below the strike price when the contract expires, they can sell the stock for more than its current price and make money. The profit the investor who owned the put option contract on would be a loss to the other party who sold that put contract which, when it is the broker-dealer, could cause the broker-dealer to lose money on that transaction.

That is how it works and they can’t avoid it. However, they can position themselves to profit on something else and this is through the delta-hedging strategy.

To protect themselves from this risk, the broker-dealer will sell some of the same stock (something called “short selling”) that the put option contract is written against. This way, if the underlying stock goes down, the broker-dealer will make money from the stock they sold short (they can buy it back in the future at a lower price than they sold it and keep the difference), which will help balance out any money they might lose on the put option.

As time passes, investors will either sell back their options to the broker-dealer to collect their profits or they exercise their right to sell the stock at the higher price the put option contract allows them to sell if for OR, if other investors step in to by the stock before the contract expires and the stock price climbs in value, thus the value of the put options outstanding will decrease and the risk exposure to the broker-dealer will decrease causing them to buy back the shares of stock they had sold.

When any of these events happens, the broker-dealer is able to buy back the stock they sold short, use those profits to fulfill their contractual obligation, and make money on the transactions.  

How much trading do broker-dealers do on an average day to Delta Hedge?

It’s difficult to pinpoint an exact percentage of daily stock trading volume attributed to broker-dealers buying and selling shares to hedge their option positions, as this can vary greatly depending on market conditions and the specific stocks involved. However, it is generally acknowledged that broker-dealer hedging activity can contribute significantly to the overall trading volume, especially for stocks with substantial options trading activity.

The impact of broker-dealer hedging on daily volume can be more pronounced during periods of increased market volatility or when a stock experiences significant price moves. In these situations, broker-dealers may need to adjust their hedges more frequently, which can lead to an increase in trading volume.

 

The Asymmetry of Puts and Calls: Why Puts Accelerate Losses Faster Than Calls Accelerate Gains

The big thing I want you to know is that put options can make the stock market fall faster than call options can make it go up. This is because of something called “asymmetry.”

Asymmetry means that things are not the same on both sides. In the case of options, this means that put options have a stronger effect on the stock market when it goes down, while call options have a weaker effect when it goes up.

Let’s use an example to understand why this happens:

Imagine you have a put option that lets you sell a stock for $100, even if the stock’s price falls to $80. If the stock price drops to $80, you can still sell it for $100 using your put option, making a $20 profit. This is great for the person who bought the put option, but not so good for the broker-dealer who sold it.

To protect themselves from losing money, the broker-dealer will sell the stock in the market. This helps them balance out their risk, but it also pushes the stock price down even further. As more and more people sell their stocks, the stock market falls faster.

On the other hand, call options work differently. If you have a call option that lets you buy a stock for $100, and the stock’s price goes up to $120, you can buy the stock for $100 and then sell it for $120, making a $20 profit. However, in this case, the broker-dealer who sold the call option can simply buy the stock at the higher price, without affecting the stock market too much.

This is why put options can make the stock market fall faster than call options can make it go up. When lots of people have put options, it can create a chain reaction that causes the stock market to drop quickly.

Extreme Decline in Stocks - Negative Gamma Squeeze

Now that we’ve discussed the asymmetry of puts and calls, let’s explore a related concept called the reverse gamma squeeze. This phenomenon is less common than a regular gamma squeeze, but it’s still important to understand how it works.

A reverse gamma squeeze, also known as a negative gamma squeeze, can occur when a stock’s price starts falling. When this happens, some investors might buy more put options. Remember, put options are like special tickets that allow people to sell a stock at a specific price for a limited time. As more people buy these put options, the people who create these options, called market makers, need to balance their own risk.

Market makers are like the helpers in the stock market who make sure there are enough options for everyone who wants to buy them. They don’t want to lose money if the stock price goes down, so they use a strategy called delta hedging. In this case, delta hedging means selling the actual stock to balance their risk from selling put options.

As market makers sell more of the stock, there are more shares available in the market, and the stock price can fall even more. This drop in the stock price changes something called the “delta” of the put options. The delta is like a measuring stick that tells us how much the price of the put options will change when the stock price changes. As the delta increases, market makers have to sell even more shares to stay balanced, creating a cycle that can make the stock price drop quickly. This cycle is known as a reverse gamma squeeze or a negative gamma squeeze.

Let’s think about it with an example. Imagine there’s a toy company, and its stock price starts to go down. Some investors think the price will keep falling, so they buy more put options. The market makers, who create these options, need to balance their risk by selling more of the toy company’s stock. As they sell more shares, the price keeps going down, which means they have to sell even more shares to stay balanced. This cycle can make the toy company’s stock price fall really fast.

While reverse gamma squeezes can happen, they’re less common than regular gamma squeezes. One reason is that when stock prices fall, they often do so quickly, which can limit the time for a reverse gamma squeeze to develop. Another reason is that investors might be more cautious about buying put options compared to call options, as stocks that are falling too much can sometimes bounce back quickly.

Identifying Warning Signs of Rapid Losses in the Stock Market

Now that we know how put options can cause the stock market to fall fast, what can we do to protect ourselves? One thing we can do is pay attention to “open option contracts.”

Open option contracts are options that have been bought or sold but have not yet been used. By looking at the number of open put options, we can get an idea of how many people might sell their stocks if the stock market starts to fall. If there are a lot of open put options, it could be a sign that the stock market might fall quickly.

Here are some things to look for when trying to figure out if a lot of open put options could cause the stock market to drop:

  1. The ratio of put options to call options: If there are more put options than call options, it could be a sign that more people are worried about the stock market falling.

  2. The expiration date of the options: If a lot of put options are set to expire soon, it could mean that people will sell their stocks quickly, causing the stock market to drop.

  3. The prices of the options: If put options are more expensive than call options, it could be a sign that people think the stock market will fall.

By paying attention to these warning signs and understanding how delta hedging works, you can be better prepared to protect your investments and navigate the ups and downs of the stock market. Remember, knowledge is power, and the more you know about how the stock market works, the better choices you can make with your investments.

How Investors Can Protect Themselves and Profit from Broker-Dealer Hedging

Now that you understand a little about Delta-Hedging and how it can influence the stock market’s direction, it is time to discuss how you, the investor, can protect yourself from this phenomenon and even position yourself to profit from it. 

Preparing Your Portfolio for Potential Market Drops

Diversifying investments to reduce risk

One of the most common ways to protect your portfolio from potential stock drops is by diversifying your investments. This involves allocating your assets across various types of investments, such as stocks, bonds, and real estate, and within different sectors, industries, and geographical locations. Diversification helps spread your risk and reduces the impact of a single underperforming asset on your overall portfolio but it doesn’t reduce systemic risk which is the type of risk that occurs when the entire market is affected.

Using defensive stocks and sectors to protect your portfolio

Defensive stocks and sectors are those that tend to perform relatively well during market downturns. These often include consumer staples, utilities, and healthcare companies, as their products and services are typically in constant demand, regardless of economic conditions. By incorporating defensive stocks into your portfolio, you can help cushion the impact of market declines on your investments.

Considering bonds or other fixed-income investments for stability

Bonds and other fixed-income investments can provide stability to your portfolio during times of increased market volatility. These investments generally offer regular interest payments and are considered lower risk than stocks. By allocating a portion of your portfolio to fixed-income investments, you can help balance your investments’ risk and reward profile and potentially reduce the impact of market declines.

Hedging Your Own Investments

Understanding how PUT Options can act as insurance for your portfolio

Put options give the holder the right to sell a security at a predetermined price within a specified time frame. By purchasing put options for your investments, you can effectively “insure” your portfolio against declines in the value of your underlying assets. If the market drops, your put options will increase in value, helping to offset losses in your portfolio. This also has the added benefit of providing you with additional equity to buy additional shares. There is a premium to purchase PUT Options that needs to be considered as the premium may cause drag on your portfolio’s performance. 

Using options strategically to protect your investments

Options can be used in various strategies to hedge your investments against market declines. For instance, you can use protective puts to guard against potential losses or employ more advanced strategies like collars (selling a call to generate premium and using that premium to buy puts) which will allow you to have some upside if the stock increases while providing downside protection if the stock declines or “iron condors” (a option selling strategy that sells both a call and a put spread on a stock without owning the stock) to limit your downside risk profit if the stock stays within a certain trading range.

It’s essential to educate yourself on these strategies if you chose to implement them on your own. These are two of the strategies we use at Decision Tree Financial to provide a hedge to our clients so they can “invest like the house” and make money in up, down and sideways markets without have 100% of their money at risk at any given time.

Considering inverse or bear market ETFs to profit from market declines

Inverse or bear market ETFs are designed to move in the opposite direction of the underlying index they track. By investing in these ETFs, you can potentially profit from market declines, helping to offset losses in other areas of your portfolio. However, it’s essential to understand the risks associated with these investments, as they can also amplify losses during market upswings.

Profiting from Market Volatility

Trading volatility with options or VIX-related products

Investors can take advantage of market volatility by trading options or VIX-related products, which are designed to track the level of volatility in the stock market. By trading options, you can profit from the ups and downs of the market, while VIX-related products can potentially generate returns during periods of heightened market uncertainty.

Identifying potential opportunities in oversold stocks or sectors

Market declines often create buying opportunities, as investors may panic-sell stocks, driving their prices down to levels that undervalue the companies. By carefully researching oversold stocks or sectors and identifying potential opportunities, you can capitalize on market declines by purchasing these undervalued assets at attractive prices.

Using market-neutral strategies to take advantage of price swings

Market-neutral strategies aim to generate returns regardless of the market’s overall direction. These strategies typically involve taking long and short positions in assets to profit from price swings without being heavily exposed to market trends. By employing market-neutral strategies, you can potentially benefit from market volatility without taking excessive risk.

Final Thoughts on Delta Hedging

There are a lot of people who feel that the stock market is manipulated and the odds are set against the “average investor.” In reality, there are a number of dynamics that help cause the stock market to behave somewhat irrationally. 

In the big scheme of things, I don’t believe investors should ever be putting 100% of their money at risk to hopefully generate 11% or less return. There are more efficient ways to generate returns, and these strategies position the investor to take advantage of opportunities that other investors who don’t employ these strategies can’t.

Delta hedging and “Gamma Squeezes” are real things that happen in the market so the industry can continue to make commissions off of the risk you take with your money. You can leave yourself exposed to the ups and downs these phenomenons cause or you can choose to position yourself to be protected from them when they happen and even take advantage of them so that you have the potential to increase your networth.

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