Option Liquidity and Gamma Imbalances

44 Pages Posted: 30 Jun 2022 Last revised: 9 Jan 2023

See all articles by Leander Gayda

Leander Gayda

University of Münster - Finance Center Muenster

Thomas Gruenthaler

University of Muenster - Finance Center Muenster

Jan Harren

University of Muenster - Finance Center Muenster

Date Written: June 16, 2022

Abstract

We study the relationship between the market makers' inventory and liquidity for S&P 500 options. Option spreads are higher when the aggregate gamma inventory is negative, i.e., when market makers act as momentum traders to keep their portfolio delta neutral. Aggregate gamma inventory can explain up to 1/3 of the daily variation in spreads. We show that market makers have balanced gamma inventory whenever markets are illiquid, volatile, and financial intermediaries are constraint. Our results indicate that market makers actively adjust option expensiveness to balance their inventory in the desired direction. Standard option valuation models and market microstructure theories contradict our findings.

Keywords: Liquidity Risk, Option Markets, Option Liquidity, Liquidity Spirals, Hedge Demand, Gamma Risk

JEL Classification: G12

Suggested Citation

Gayda, Leander and Gruenthaler, Thomas and Harren, Jan, Option Liquidity and Gamma Imbalances (June 16, 2022). Available at SSRN: https://ssrn.com/abstract=4138512 or http://dx.doi.org/10.2139/ssrn.4138512

Leander Gayda

University of Münster - Finance Center Muenster ( email )

Schlossplatz 2
Muenster
Germany

Thomas Gruenthaler

University of Muenster - Finance Center Muenster ( email )

Universitätsstraße 14-16
Muenster, D-48143
Germany

HOME PAGE: http://sites.google.com/view/tgruenthaler/

Jan Harren (Contact Author)

University of Muenster - Finance Center Muenster ( email )

Universitätsstraße 14-16
Muenster, 48143
Germany

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