Liquidity

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We have covered so much up to this point of the course. This has prepared us for the lesson where we will talk about the market liquidity, what moves it, and how our Q models can help us invest better by following the positioning of market makers. We have talked about delta hedging creeks and now we are putting all together in this section. Let's go. When we talk about liquidity, we talk about volumes, capitals that can push the market up or down.

[00:00:22.12] - Speaker 1
The markets, if we want to summarize, are nothing more than that. Capital positioning drives asset liquidity up and down. The investor's goal is to understand what are the factors that condition the market in the short term and in the long term. Liquidity is crucial for financial markets for many reasons. The first is efficient trade execution.

[00:00:41.06] - Speaker 1
Liquidity ensures that market participants can buy or sell security quickly at reasonable price. When there is high liquidity, it is easier to execute trade without impacting market price. Traders can enter and exit positions smoothly, facilitating efficient portfolio management and risk mitigation. Then we have price stability. In liquid markets, large trades can be absorbed without causing significant price changes.

[00:01:03.27] - Speaker 1
This stability is especially important for option traders who may need to execute multiple contracts. And finally, risk management. Liquidity plays a crucial role in risk management. Traders rely on the ability to quickly adjust their position in response to changing market conditions. Liquid markets provide the flexibility to manage risk efficiently, allowing traders to hedge, adjust or exit position as needed.

[00:01:26.15] - Speaker 1
Being able to follow the liquidity levels in the market can help us in several ways. First, it can help us track volatility levels. Understanding what drives volatility up can help us be better positioned based on volatility levels. It can also help us position a portfolio in case of tail risk events. It is obvious that when there is a black swan event, it is always difficult to be well positioned.

[00:01:47.13] - Speaker 1
But smaller correction events can be predicted by looking at investor positioning. Finally, we can benefit from bullish movement. For example, technical movement can be predicted by following RQ models in the morning. An example before major events, participants build up a lot of protection in the form of put or bearish spread strategies. This leads to an excessive accumulation of puts which drives volatility up.

[00:02:09.11] - Speaker 1
Following the event, these positions are closed and the collapse of volatility leads to a technical increase of the underlying price. Understanding how these events work and being able to follow market positioning can help improve your returns. Whenever an investor takes a position in a call or a put option on the other side of the transaction, there will be a market maker who has to manage his own risk. The market maker does not want the directional risk associated with the position. The market maker does not want to lose or gain from a rise or fall of the spot price.

[00:02:38.03] - Speaker 1
Therefore, he hedges his risk by taking a dynamic position in the underlying asset. The objective of this activity is to cover the change in delta through delta hedging. In one of the previous lessons, we have talked about the concept of federation. This will help you to understand the next example. In fact, if we buy a not the money call option, the market maker has to sell about 50% of the nominal value of the position.

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We know that because the not the money option has a delta of 50. Now the important part from a liquidity standpoint is the next slide. If the spot changes in value, the market maker must buy or sell the underlying to remain delta hedged. Their goal is to maintain a delta neutral position. The delta hedging activity of the market makers has market price implications.

[00:03:18.25] - Speaker 1
This is because the market makers activity has the effect of adding or removing liquidity from the market. For example, an investor who sells an option adds liquidity to the market because the market maker must inject liquidity to remain delta neutral. On the other hand, an investor buying an option is removing liquidity from the market. We will talk about this in more detail later in this section. At this point it will come as no surprise that our real goal to track liquidity is to follow the movement of the Delta.

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But what affects the delta? During the course, we have studied all the Greeks in detail. From first to third order Greeks. Our goal is to understand how these Greeks move. When we look at liquidity, the movement of each Greek allows us to understand how the delta moves.

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Our goal is to understand how the market maker is then positioning himself to return delta neutral. And this is an event that moves liquidity. Liquidity and the positioning of any investors is conditioned by three spot and strike implied volatility and time. When these factors change, even if our starting position is delta neutral, we have to reposition ourselves. All these factors can be quantified by the Greeks.

[00:04:21.29] - Speaker 1
Following the Greeks must be our way of doing a risk management. And this applies also for the market maker. Gamma helps us understand how the spot price is moving. The speed of the spot price movement changes the delta of our position. The Vega and Vanna focus on the movement of implied volatility.

[00:04:38.13] - Speaker 1
If the volatility goes up based on the manliness of our option, we have to re hedge our position. And finally time. The passage of time affects the value of our options every day. It is a factor that we cannot ignore whether we are long or short options. At this point, we can look at this mechanism in more detail.

[00:04:55.10] - Speaker 1
This will help us follow our Q models, but also the Mentor Q Report. When we talk about liquidity in the morning, the first thing we know and that we touched on briefly earlier is that by selling an option we are creating liquidity in the market thanks to the market maker. The opposite happens when we buy where we are removing liquidity. Let's see why and let's look in detail how investor and market maker positioning changes liquidity. If as an investor we buy a call, we know that the market maker will short a call.

[00:05:21.02] - Speaker 1
On the other end, to be delta neutral, the market maker has to buy the underlying asset. If we sell a call to receive a premium, the market maker will be long a call. And to be data neutral, the market maker has to sell the underlying. When we buy a put, the market maker is short put and must sell the underlying to be delta neutral. Finally, by selling a put, the market maker is long put and this forces him to buy the underlying to be delta neutral.

[00:05:44.08] - Speaker 1
What we do know is that in most cases the market tends to be in positive Gamma. This means that the market maker's positioning to remain delta neutral is good for the market. Positive Gamma tends to be good for returns of investors because the market makers buy when the market goes down and sell when it goes up to stay Delta neutral. If this concept is not clear, we suggest you to go back to the section about Delta hedging and the practical examples. So we know that hedging based on Gamma is a matter of market direction and the speed of that change.

[00:06:12.08] - Speaker 1
If everything stays the same as investors, we follow Gamma. And as long as Gamma is positive, delta hedging activity remains positive for our profit and loss. This changes if we are in negative Gamma because in this case the market maker to be covered, sells when the market goes down and buys when it goes up. This means that if we buy and sell at the wrong time, we lose money. In our daily report, our Q models show you this in a very simple way.

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If the price is in the green box, we are in positive Gamma. We can expect low intraday movements and low volatility in negative Gamma. Instead, the market becomes very volatile and the price moves sharply intraday. The indicator in our model that tells us if the Gamma is increasing or decreasing is the jax. You can see it here in yellow.

[00:06:54.15] - Speaker 1
Gamma though is not the only reason why the market maker must hedge. In addition to Gamma, the market maker must look at the volatility movement. So while Gamma is a matter of movement of the spot hedging. The implied volatility is a matter of the moneyness of the option. One of the things that we have repeated several times during the course is that an option has intrinsic and time value.

[00:07:13.26] - Speaker 1
As we can see from the slide, both values change the closer we get to add the money. If we own an out of the money call away from the at the money strike, we know that if there is low volatility, the option has little chance of entering in the money by experience ratio. This is a very important concept because as we said before long, gamma or short gamma are positive or negative for liquidity in the market. The same goes for volatility. Increased volatility changes the moneyness of an option and this changes the delta of the option.

[00:07:41.09] - Speaker 1
At this point, we know that implied volatility increases when liquidity is low and decreases when liquidity is high. So positive gamma is negative volatility and vice versa. When an option is sold, the JAX increases and this lowers the implied volatility. This is what in the Q models we call vex. The opposite happens when we buy options.

[00:08:00.01] - Speaker 1
But that's not all that would be too easy. The problem arises when we look at out of the money positions, More specifically, short out of the money puts. In fact, the market maker is forced to sell when the volatility rises in order to remain delta neutral. And this is a problem when it comes to out of the money puts, because in that case, in a market crash, the market maker is short when the market falls. If we go back to our qmodels, we can see there are different levels every morning.

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In the main chart, the three main ones are the call resistance, the eyeball level and the put support. In the practical section, we will talk about this in detail. The put support level matters more to us because it's in line with the concept of volatility and out of the money puts. When the volatility goes up. What we notice is that the lower levels of the put support are the ones that are broken by the price to the downside.

[00:08:47.02] - Speaker 1
This is due to the fact that the more the price falls, the closer the out of the money puts gets to the at the money strike. This increase in volatility pushes the market maker to short the market to continue being delta neutral, creating the typical market crash of 2020. With this, we will end the liquidity section and the theoretical part of the course. It's time to move to the practical section.