Option Liquidity and Gamma Imbalances

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