Volatility and You: How Underhedging Creates Crashes

by justcool393

TL;DR: The market is, in general, underhedged. Lack of hedging with put options is creating a scenario that makes our ability to rally upward much harder and increases crash risk. Buy short-dated ATM straddles (more risky), buy puts, directly short the S&P 500 (less risky), or stay in cash (not really risky at all) (see “How to position yourself”).


– Boeing 787 MAX TAWS, being piloted by Captain Powell

Let’s talk about options! The S&P 500 (SPX) has the most liquid options market in probably the world. Now sometimes people, instead of using these derivatives for gambling based on what side of a yard a dog poops on, use them to hedge their exposures to stocks and the market.

They are bought and sold by market makers (Citadel’s the king, obviously, but there are others). People (in general) buy put options and sell call options. Sometimes though, there are speculators who would buy call options and sell put options (think WSB, thetagang, your grandfather’s pension, etc).

Market makers want to do one thing: capture the spread between the bid and the ask price. They don’t care about short ladders or whatever. They’ll happily be long or short SPX, GME1, TSLA, whatever if it makes them more money.

In order to hedge their exposure to the movement of stock price action (gamma), volatility (vanna), and time (charm), they buy and sell /ES (S&P futures) to hedge to their delta2.

If dealers are negatively exposed to gamma, things get a bit volatile but if dealers get negatively exposed to vanna, things get real volatile real fast because they are selling into selling (which increases implied volatility, leading to more required delta hedging) and buying into buying (which decreases implied volatility, leading to more required delta hedging) in order to hedge.

To explain with a simple analogy: that crazy ex, she’s vanna. Vanna will take you to your highest highs but will also take you to your lowest lows. And… yeah those lows will be low. And no, I’m not going to help you “get over” her. And by the way, my bf is coming over for the week so we’ll need the house.

Back to options.

It’s worth noting that dealers quote their options in volatility terms, not dollars and cents3. But implied volatility is relatively low for a 1000 point drop right now and isn’t increasing as we drop.

This is because there are a lot of people systematically selling puts, driving down IV. And because IV is being driven down by the put sellers, bulls can’t get a sustained bear market rally (since these rallies are often fueled by rehedging)

But it’s pretty obvious to anyone who’s traded that realized volatility has far outstripped implied volatility (especially on the “FDs”) and that FDs are relatively cheap. VIX is 29 right now, which implies about a 2%ish (off the top of my head) move each day. We’re getting multi percent intraday moves, even if close-to-close we’re going relatively slow. This is absurd.

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I could go on but you get the point already so let’s move on.

How to position yourself

So… there are a couple ways you can play this relatively historic event depending on your risk tolerance (from most risky to least risky)

  1. Buy straddles extremely close to expiration, especially on days with large intraday moves. Because IV is chronically underpriced here, you should be able to make money buying 0 DTE straddles. Don’t use Robinhood or anything like that, they’ll screw you over by market selling your position early. Also don’t do it systematically, because you will lose out when you don’t get the move you want.
  2. Buy somewhat longer term put options. SPX 6/21 3800p (SPY 6/21 380p) is probably a decent option and has a decent chance of going ITM. You can sell on a volatility spike or keep them going into expiration.
  3. Keep hitting those tails. 3σ 30 DTE SPY put options (it’s currently SPY 6/21 305p) are only 13bps ($0.50). On a massive move, those tails will explode in value. You’re not going for them going ITM, you’re going for P/L so you can unload your bags onto Citadel. Buy them when VIX is in the 20s.
  4. Short E-Mini S&P 500 futures (/ES or /MES) or SPY or something. This will be probably the least gut wrenching thing to do. You’ll make a lot of money, but you probably won’t get a heart attack in 20 years from the stress of watching options change rapidly in value. So… it has its downsides. Wait for a large volatility blow up (look at VIX) or for Fed to reverse course to unload your position.
  5. Go cashgang. Sure you’ll miss out on gains, but you’ll only decay at 8%/year vs. the 30%+ drop (+ decaying at 8%/year). You can place $10k into I-bonds if you’re worried about inflation at an interest rate of 9.62% risk-free.

(My positions are #4 and a bit of #3 opportunistically.)

Good luck WSB, you’re gonna need it.

Some anticipated criticism

But volatility is heteroskedastic!

Your criticism here is basically that IV doesn’t move 1-to-1 with SPX and while that’s true, realized volatility is still above implied volatility (VIX should be like in the 40s). But implied volatility is still implying that there isn’t hedging and a deeper analysis reveals that in general, there are a lot of put sellers.

There’s also a pretty well established inverse correlation in SPX with IV in general (although don’t naively apply this to single stocks, especially ones like GME).

But volatility should be low for a sustained drop!

Sure but volatility isn’t constant and is based on a few things including how “””fearful””” the market is. And even so, even if we sustained a constant move down every single day (which we don’t) you’d still have gamma P/L to contend with. This alone makes it so that volatility is 0 or whatever but it’s also dependent on other factors here. What I’m contending here is that these factors are such that volatility is massive underpriced, especially with the massive intraday moves that we are seeing.

VIX is a bad volatility index!

Yeah I know but I used it for simplicity. Anyone in the vol space knows that SPX vol and skew (not the SKEW index!) isn’t being bid up all that much relatively so… yeah.


  1. Stocks like GME and AMC which have relatively predictable behavior (i.e. lots of people buying call options to force rallies and rehedging) are very profitable for market makers like Citadel because they are able to collect very wide spreads on the options. MMs got caught offsides a bit by the January 2021 event (basically the options chain acted as if every option was 50Δ) and the gamma profile was very negative then, as anyone who works on a desk will tell you (this is what the SEC got wrong in their report). It’s an interesting happening, but it’s a story for another time.
  2. Plus some to account for skew. Also, it’s worth noting that delta-hedging exists independent of BSM. You still have to hedge for price movements, volatility, and time even if you aren’t pricing your options using BSM, which practitioners don’t.
  3. Remember that everything except for volatility and rates are known observables so these are the only two things that can really be “priced” per se. Something like BSM can be used to map IVs to dollars and cents.


Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence or consult your financial professional before making any investment decision.


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