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Option Gamma and Associated Future Stock Returns

Steve LeCompte | | Posted in: Equity Options, Equity Premium

Guide Options and Leveraged ETFs Other option research

Key Insight

Low-net-gamma stocks outperformed high-net-gamma stocks (1.45% vs 0.58% gross average next-month return; 0.87% monthly spread, value-weighted extreme deciles; U.S. stocks over $5, Jan 1996–Dec 2021; monthly sorts, before costs and shorting frictions).

Is option gamma, which indicates how aggressively option market makers must trade underlying stocks to hedge their option positions, a systematic driver of those stock returns? In his October 2022 paper entitled "Option Gamma and Stock Returns", Amar Soebhag investigates the relationship between option gamma for individual stocks and future returns of those stocks. He defines net gamma exposure of a stock as a hedge-adjusted, gamma-weighted sum of open interest for options written on the stock. He each month sorts stocks into value-weighted tenths (deciles) by net gamma for the previous month and calculates next-month returns on the decile portfolios, with focus on the difference in returns between extreme deciles. He then looks at behavior of net gamma across stocks, interactions of net gamma with other stock return predictors and time variation of aggregate net gamma. Using daily gamma, open interest, implied volatility and trading volume for each option contract on listed U.S. common stocks price over $5 as available during January 1996 through December 2021, as well as contemporaneous returns for underlying stocks and data for other widely accepted stock return predictors, he finds that:

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Options and Leveraged ETFs guide

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