Recent analysis from JPM QDS indicates that option-based Exchange Traded Funds (ETFs) are playing an increasingly significant role in shaping the volatility landscape of financial markets. Particularly, these funds have been instrumental in dampening short-term volatility, thanks to the gamma supply they provide.

Gamma, a measure of the rate of change in an option’s delta for a one-point move in the underlying asset, is a key driver of implied volatility levels. According to the latest data, option-based ETFs have escalated their gamma supply from a mere $0.2 billion to a substantial $5 billion over the past three years. This substantial increase reflects a broader trend where such strategies are becoming major forces in volatility suppression.

Alongside gamma, these ETFs supply approximately $65 million in vega monthly, a metric that measures an option’s price sensitivity to changes in the volatility of the underlying asset. A notable point here is that this vega supply is primarily originating from call overwriting strategies. This strategy involves holding a long position in the underlying asset while also selling a call option on that asset, which can generate income but also cap the upside potential if the asset’s price rises above the call’s strike price.

However, experts caution that this volatility suppression is not without its risks. In the event of a significant market downturn, the stabilizing influence of these option-based ETFs may quickly evaporate. Without the counterbalance provided by gamma and vega from these strategies, the market could become more susceptible to aggressive selling pressures. Potential sources of such selling include volatility-targeting funds, Commodity Trading Advisors (CTAs) or momentum investors, and other entities engaged in short gamma strategies, such as hedging puts and operating leveraged ETFs, along with discretionary investors.

What’s more concerning is that other short volatility strategies, which might have grown dependent on the calming effect of these overwriting funds, could find themselves with little support in scenarios where market tail risks materialize. In essence, while these strategies offer a buffer in normal market conditions, their protective capability may be limited when markets face extreme stress.

While option-based ETFs have become a cornerstone in the current structure of market volatility, their role comes with an implicit warning. They contribute to the stability of the markets under regular conditions but can also lead to increased vulnerability during market shocks. This dual nature serves as a reminder to investors and strategists to consider the broader implications of volatility-suppressing strategies within their overall risk management frameworks.