Gamma Fragility

Asset Pricing Implications of Delta-Hedging

Working Paper

We document a link between large aggregate dealers' gamma imbalances and intraday momentum/reversal of stock returns, arising from the potential feedback effects of delta-hedging in derivative markets on the underlying market. This channel relies on limited liquidity of the underlying market, but it 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 equity options that we use to compute a proxy of stock-level gamma imbalance. We find supporting evidence that intra-day momentum (reversal) is explained by the interaction of negative (positive) ex-ante gamma imbalance and and illiquidity. The effect is stronger for the least liquid underlying securities. Our results help to explain both intra-day volatility and autocorrelation of returns. Moreover, we find that gamma imbalance is related to the frequency and the magnitude of flash crash events.

Last Revision: 2021-03-19

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