Nº 22-34: On the Directional Destabilizing Feedback Effects of Option Hedging

We investigate the feedback effect of option hedging activity on the stability of the price of the underlying. While previous literature has focused on the effect of hedging activity on the volatility of the underlying, this paper focuses on directional instabilities arising from feedback effects. We propose a model in which the drift of the underlying is affected by delta hedging and couple the predictions of this model with an approach to identify short-lived, locally explosive trends in the expected price evolution. We show that such directional instabilities indeed occur with higher or lower intensity (depending on the option parameters and its delta) when option hedging is present, in line with the predictions of our model. Analytical results and synthetic experiments furthermore suggest that the effect of hedging on price stability is strongly asymmetric, with a significantly more pronounced effect on the spot price when the option market maker is short compared to long the option. Since the regime where the market maker is short is the predominant regime empirically, this suggests that option hedging indeed can be expected to impact and even destabilize prices. Using the example of the GameStop stock in early 2021, we investigate the predictions of our model on empirical option positions and document that there are indeed instances where explosive trends due to hedging were more likely. In line with other studies of the event, we however also find only limited evidence that option hedging was a main contributor to the observed large-scale price dislocations in this particular case.