2.1 The Tail Wags the Dog

The Chicago Board Options exchange (CBOE) is one of the largest U.S. equities market operators, providing trading and clearing services for a wide range of derivatives products. Since its start in 1973, the options market has grown from less than 1000 daily contracts to averaging over 10 million daily contracts traded, with the aggregate value of options contracts totaling roughly $700 billion. At first glance, this may seem insignificant relative to the $50 trillion US equities market cap, but has a significant impact once considering leverage and hedging.

An option is a financial instrument that gives someone the right, but not the obligation, to buy or sell 100 shares of an underlying security at an agreed upon price and date (although are settled in cash for indices and futures). These options contracts are inherently leveraged, where the change in the value of the contract can be much larger than the change in the value of the underlying equity. This leverage is called lambda, and is given by

where V is the option contracts value and S is the underlying spot price. This levering effect means that the roughly $700B in contracts have a delta value of $5T, or roughly 10% of the total equity market value (with a current lambda of about 6.5).

The above impact only represents the net open options on the market, and disregards the fact that many more options are traded (open and closed) than persist open from day to day. This dynamic is most apparent for the S&P 500 index options, where hundreds of thousands of contracts are traded each day with same day expiration. If you add up all of the volume of contracts traded and calculate their total delta, it is equivalent to roughly 80% of all of the daily volume in the stock market. If you include dynamic hedging from index futures trading, this number increases to as large as 400% of equity volume! Even though the delta of every single trade is not necessarily hedged, the quantity of trading activity in derivatives likely makes up the vast majority of all trades on the stock market.

The stock market is now primarily driven by derivatives trading. The tail wags the dog

With this framing of the stock market, it becomes clear that to understand market movements, one must understand order flow. To understand order flow, one must understand options positioning.

But who is mechanically performing all of this stock trading in response to options trading? Enter the market maker…