Wall Street dealers in hedging frenzy get blamed for volatility

Two professors have just lent academic heft to a suspicion running rampant on Wall Street all year: The options market is whipsawing share prices like never before.

As retail investors spur a boom in derivatives trading to rival actual stock volumes, dealers rushing to hedge themselves are said to have fuelled the 2020 melt-up in tech names from Netflix Inc. to Microsoft Corp. They’re also suspected of amplifying two big drawdowns in September and October.

New research sheds light on just how this dynamic tends to play out.

A study from the Imperial College Business School and the University of St Gallen has concluded that structural changes to the industry in the past two decades mean dealers are indeed contributing to intra-day volatility as they balance their exposures.

It’s the latest evidence supporting traders who have long argued that the derivatives boom is increasing market fragility. The more mainstream members of the finance community are now playing catch-up.

“This paper is the first high-profile one to really give the idea a proper treatment,” said Matt Zambito of SqueezeMetrics, an analytic service that tracks derivatives exposure. “People are taking these ideas seriously now,” he said.

At the centre of it all is what’s known as gamma hedging. That’s when options market makers — the likes of Citadel Securities and Susquehanna International Group — buy or sell an underlying stock to manage their risk as the price of the shares moves.