A Simple Guide to Option Order Flow & Market Maker Hedging
A short but easy to follow guide on how to trade and understand option order flows
Hey BF Members, as promised, we’d do a free piece here on how to understand option order flow and market maker hedging.
I’m creating this guide because by understanding dealer gamma and order flows, we can understand the dealers hedging impact upon the current open interest and option orders in the market.
Option dealers and market makers are some of the most active players in the market.
If I buy 100 SPY call options, the dealer is short 100 SPY call options. Then they have to hedge those short SPY calls because it leaves them directionally exposed if the market rises.
So they will ‘hedge’ their position buy doing what?
Getting long SPY or futures.
If I’m buying 100 SPY call options at 50 delta, then they are short 100 SPY calls at 50 delta.
So how do you hedge 50 delta short calls, by getting long 50 SPY x option contracts exposure (100) so long 5000 SPY’s or 5000 futures.
And there you go, there’s your first simple example of how hedging takes place by option dealers and market makers.
Below is a simple trader/dealer breakdown of the positions if a trader gets long/short calls, and how that impacts the dealers.
Example 1: Trader is long calls / Dealer is short calls
If the trader is long calls, this makes the dealer short calls since they are on the other side of the transaction.
This means the dealer gamma is negative (because when you are short calls, you are short gamma).
This also means dealer delta is long futures.
As time passes and the options decay, the dealer sells those futures.
As volatility declines, the dealer sells those futures.
Example 2: Trader is short calls / Dealer is long calls
If the trader is short calls, the dealer is long calls since they are on the other side of that transaction.
The dealer gamma is positive (since they are long calls).
This also means the dealer delta is short futures.
As time passes and the options decay, the dealer buys futures.
As volatility declines, the dealer buys futures.
Example 3: Trader is long puts / Dealer is short puts
If the trader is long puts, then the dealer is short puts since they are on the other side of that transaction.
The dealer gamma is negative since they are short puts.
This also means the dealer delta is short futures to offset the downside exposure.
As time passes and the options decay, the dealer buys futures.
As volatility declines, the dealer buys futures.
Example 4: Trader is short puts / Dealer is long puts
If the trader is short puts, the dealer is long puts since they are on the other side of that transaction.
The dealer gamma is positive since they are long puts.
This also means the dealer delta is long futures to offset their upside directional exposure.
As time passes, the dealer has to sell those futures.
As volatility declines, the dealer has to sell futures.
NOTE: If the option being traded by the trader is a single name stock, then the dealer will simply get long the stock and not futures.
How does this help you as a trader?
There’s a litany of ways this info can help you as a trader, but I’ll name 8 order flow scenarios to give you an idea:
When the markets are in positive gamma (i.e. net long options), volatility tends to be subdued
When the markets are in a negative gamma position (i.e. net short options), volatility tends to be increased
If the dealer does not currently have long stock on XYZ stock, and XYZ stock is being furiously bid up via long calls from traders, this can create a gamma squeeze as a) the dealers are short calls, so they have to long the stock to hedge, and b) as more and more calls are bought, dealers have to buy more stock
Long calls (i.e. long gamma) increases the value of those calls as they rip higher because gamma accelerates (i.e. increases) as the market rips higher
Eventually those long calls get close to a delta of 1, which means the dealer has a lesser hedging (delta) impact as the stock rises. This reduces the fuel for a gamma squeeze as dealers are buying less of the stock as it rises
Eventually the IV and deltas are well hedged to the point where dealers can start selling as the stock rises to offset their positions
When this happens, it becomes really hard for stocks to rise because they are running into dealers selling
This same scenario can happen to the downside where dealers no longer need to sell to offset their position. When this happens, it becomes really hard for stocks to go lower because they are running into dealers buying the stock to hedge
So there you have option market maker order flow in a nutshell. I suggest all traders (both stock and option traders) learn these rules inside and out because they will give you an idea of how the dealers and market makers will (or may) react when the calls and puts start flying.
If you learn to read option order flows via the open interest and volumes at particular strikes, you’ll eventually be able to spot potential gamma squeezes, areas where dealers have to hedge, and where they will make it harder for a stock to rise or fall.
If you’d like to learn more about option dealer order flow, along with 8 strategies to generate income trading options, then check out my options bootcamp where I share these strategies and how to use dealer gamma, delta and the greeks to find unique trading opportunities.
I hope you found this helpful to understanding options and order flow.
Make sure to leave a comment below on what you learned from this and what questions you have.
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This article isn't easy to understand. I've read through it a few times and it's still being digested. I hope to continue to deepen my understanding as I read it again and again. The example blew my mind but the last part where you describe the 'option market maker order flow' puts it all together.
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