Dancing with Gamma: Unraveling the Intricacies of Crypto Options

Welcome to the latest Onchain Edge Newsletter, where we’ll dive deep into the world of Bitcoin options and the impact of Gamma and delta on the cryptocurrency market.

In this edition, we'll introduce you to the fundamentals of Gamma and delta, exploring their roles in options trading and how they relate to one another. We'll also examine the impact of positive and negative Gamma on an asset's price and the market's stability.

We'll then delve into the intricacies of delta hedging, explaining how traders and market-makers use this strategy to minimize risk and maintain a delta-neutral position. To help illustrate these concepts, we'll use the analogy of a car's speed and acceleration to simplify the ideas of delta and Gamma.

Next, we'll guide you through reading GEX charts, which provide valuable insights into Bitcoin options and dealers' positions. By understanding how to interpret these charts, you can anticipate market-makers reactions to price changes and make more strategic trading decisions.

Finally, we'll explore various scenarios involving changes in the BTC price, deltas, and implied volatility, illustrating the potential effects of these factors on the options market and the broader cryptocurrency landscape.

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With that said, let’s dive right in!

Enjoy!

Introduction to Gamma, Delta & Vanna

In options trading, two essential Greek letters come into play: Gamma and delta. These letters represent crucial mathematical measurements traders use to analyze and manage their positions effectively. So let's delve into the basics of Gamma and delta and explore their significance in options trading.

Imagine you're driving a car on the highway. The car's speed represents delta, while the speed changes rate represents Gamma. Just as the speed indicates how fast the car moves, delta represents an option's price sensitivity to changes in the underlying asset's price.

Now, think about acceleration. Acceleration measures how quickly the car's speed changes. When the car accelerates, its speed increases; when it decelerates, its speed decreases. In the same way, Gamma measures how quickly delta changes in response to fluctuations in the underlying asset's price. Vanna is a second-order option sensitivity measure that represents the rate at which an option's delta changes with respect to changes in implied volatility. It gauges how much the delta (car's speed) will change as the implied volatility (road conditions) changes.

Using the car speed analogy, imagine driving on the road with varying conditions. The road conditions represent implied volatility, which affects how much you need to adjust the car's speed (delta) to maintain control.

You can maintain a steady speed with minimal adjustments when driving on a smooth road with predictable conditions (low implied volatility). In this case, Vanna is low, as the delta doesn't change much with respect to the road conditions.

However, when you enter a stretch of road with unpredictable and challenging conditions, such as sharp turns or sudden elevation changes (high implied volatility), you must make more frequent and significant adjustments to the car's speed to maintain control. In this scenario, Vanna is high, indicating that the delta changes more dramatically in response to the changing road conditions (implied volatility).

+-Gamma: Cruise Control and Manual Throttle

Positive and negative Gamma are terms used to describe how the delta of an option changes in response to fluctuations in the underlying asset's price. These concepts help traders understand how their option positions will react to market movements and how to adjust their trading strategies accordingly.

Let's expand on the car speed and accelerator analogy to illustrate the concepts of positive and negative Gamma.

Positive Gamma: (Cruise Control) Imagine you are driving a car with a cruise control feature, which helps maintain a consistent speed. In this case, the cruise control acts like positive Gamma. When the car encounters an incline, the cruise control system automatically increases the engine power to maintain the desired speed. Conversely, when the car goes downhill, the cruise control reduces the engine power to prevent the car from speeding. This automatic adjustment acts like positive Gamma, counterbalancing the external factors (incline and decline) and stabilizing the speed (delta) of the car, much like how positive Gamma helps maintain a delta-neutral position for options traders and market-makers.

Negative Gamma: (Manual Throttle Control) Now, imagine driving a car without cruise control and having to control the throttle manually. In this scenario, the lack of automatic speed adjustment is similar to negative Gamma. When the car encounters an incline, you have to press the accelerator harder to maintain speed, and when the car goes downhill, you need to release the accelerator to avoid speeding up. This manual adjustment can lead to overcompensation and cause fluctuations in the car's speed (delta), similar to how negative Gamma can exacerbate price movements and increase volatility in the market for options traders and market-makers.

This car analogy illustrates how positive and negative Gamma can affect the behavior of delta (the car's speed). Positive Gamma stabilizes and smooths out the changes in the delta, while negative Gamma can amplify and intensify those changes.

In market-making and hedging, negative Gamma acts as a price accelerator. When market-makers or dealers have a net negative gamma position, they sell the underlying asset when its price falls and buy when it rises to maintain a delta-neutral position. This action can exacerbate price movements and increase volatility in the market.

The Art of Delta Hedging

In the context of options trading, delta hedging is strategy traders, and market-makers use to minimize the risk associated with price movements in the underlying asset. This is done by taking an offset position in the underlying asset to neutralize the delta or the sensitivity of the option's price to changes in the underlying asset's price.

Let's use the car speed analogy to explain the process of delta hedging:

Imagine driving (representing your options position) on a straight road, with your goal to maintain a specific speed (delta-neutral position). Your job as the driver is to constantly adjust the car's speed to maintain the desired level.

In this analogy, delta hedging is like using the accelerator and brake pedals to control the car's speed. When the road slopes uphill (the underlying asset's price increases), you must press the accelerator (buy the underlying asset) to maintain the desired speed. Conversely, when the road slopes downhill (the underlying asset's price decreases), you must apply the brakes (sell the underlying asset) to prevent the car from speeding up and maintaining the desired speed.

Throughout this process, you constantly adjust the car's speed using the accelerator and brake pedals, akin to delta hedging in options trading. By taking an offsetting position in the underlying asset, you can minimize the risk associated with price movements and maintain a delta-neutral position.

Here’s an overview of the different scenarios:

It’s a lot of information to digest. It might take some time to remember and understand everything.

That’s why I made the following cheat sheet you can use as a reference in the future:

Decoding GEX Charts: A Visual Guide to Bitcoin Options

GEX charts, or Gamma Exposure charts, provide valuable insights into the options market, particularly when understanding traders’ positions and reactions to market movements.

This section will explore how to read BTC GEX+ charts and the inGammation on Gamma and delta from the previous sections.

Above, you can see the GEX+ Graph from the Kingfisher platform, with the x-axis representing implied volatility and the y-axis representing the index price. This visual representation makes grasping the market makers’ positions and strategies when the price and IV change.

The graph uses different colors to indicate the market makers’ delta ranges, which help predict their trading behavior:

• Delta > 0 (blue-green): Market makers trade against price action to stay hedged in this range. They have a net positive gamma position and must maintain a delta-neutral stance. When the price goes up, they will sell the underlying asset; when the price goes down, they will buy it.

• Delta < 0 (purple-red): Here, Market makers trade along with price action to stay hedged. This is indicative of a net negative gamma position. In this case, market makers will buy the underlying asset when the price goes up, and when the price goes down, they will sell it.

• Delta = 0 (transparent): When deltas are hedged, a significant shift in price action is likely imminent. This situation indicates that market makers have a balanced position and are not expected to react strongly to price changes. However, it also suggests that the market may be poised for a breakout, as market makers may need to adjust their positions rapidly when the price moves.GEX+ Example 1:

In this scenario, let's examine the Bitcoin options market when the current BTC price is $24,500 and what happens if BTC shoots up to $34,341.

• Current BTC price: $24,500

• BTC price increases to $34,341

• Resulting delta: -12,273

• Maximum negative delta: -23,580

• Implied volatility: 57

When the BTC price increases from $24,500 to $34,341, the delta changes to -12,273. This negative delta implies that the dealers have a net short position on BTC. This means that dealers may need to buy more BTC to hedge their positions as the price continues to rise, which is a characteristic of a negative gamma scenario.

Since the maximum negative delta is -23,580, the current delta of -12,273 suggests that the dealers' short positions are not at their most extreme. However, as the price increases and the delta becomes more negative (closer to the maximum negative delta), dealers will likely need to buy more BTC to hedge their positions, potentially fueling the price rally and causing short liquidations.

GEX+ Example 2:

In this scenario, let's examine the Bitcoin options market when the current BTC price is $24,500 and what happens if BTC drops to $20,341.

• Current BTC price: $24,500

• BTC price decreases to $20,341

• Resulting delta: -2,919

• Maximum negative delta: -23,580

If the BTC price decreases from $24,500 to $20,341, the delta changes to -2,919. This negative delta implies that the dealers have a net short position on BTC. In a negative gamma scenario, dealers may need to sell more BTC to hedge their positions as the price drops.

However, it's important to note that the delta of -2,919 is not close to the maximum negative delta of -23,580. This suggests that the dealers' short positions are relatively mild compared to the maximum negative exposure. As the price decreases and the delta becomes more negative (closer to the maximum negative delta), dealers will likely need to sell more BTC to hedge their positions, potentially fueling the price decline.

Conclusion

Understanding the concepts of Gamma, Delta, and Vanna is crucial for options traders to analyze and manage their positions effectively. The car speed analogy helps to visualize the relationship between these concepts and how they affect the behavior of delta (the car's speed). For example, positive and negative Gamma plays a significant role in stabilizing or intensifying delta changes.

Delta hedging is a strategy that traders and market-makers use to minimize the risk associated with price movements by taking an offset position in the underlying asset. The cheat sheet provided in the article can be used as a reference for future use. Additionally, GEX charts provide valuable insights into the options market, and the article explains how to read and interpret these charts to understand traders' positions and reactions to market movements. Overall, understanding these concepts and tools is essential for successful options trading.

Let me know if you have any questions down below. Also, please share this newsletter with people who might find it helpful.

Cheers!OE

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