Gamma Fragility

Asset Pricing Implications of Delta-Hedging

Working Paper

We build on a growing literature that studies the impact of market frictions on the dynamics of stock markets, such as momentum, price spirals, excess volatility, and investigate the potential feedback effects of delta-hedging in derivative markets on the underlying market. We document a link between large aggregate dealers’ gamma imbalances in illiquid markets and intraday momentum/reversal and market fragility. This link is distinct from information frictions (adverse selection and private information) and funding liquidity frictions (margin requirement shocks). We test our joint hypothesis using a large panel of index and equity options that we use to compute a proxy of aggregate gamma imbalance. We find supporting evidence that intra-day momentum (reversal) is explained by the interaction of negative (positive) aggregate gamma imbalance and market illiquidity. The effect is stronger for the least liquid underlying securities. The result helps to explain both intra-day volatility and autocorrelation of returns.

Last Revision: 2019-09-03

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