How Options Can Calm or Amplify Market Swings

Picture a bank that sells an options contract to a client. The bank now carries risk it did not want, so it does what any sensible trader does: it hedges. How it hedges — and when — can quietly shape the market everyone else is trading in. Sometimes that hedging smooths prices. Sometimes it pours fuel on a move already underway. Economists call this bundle of behaviour "dealer positioning and hedging flows," and it is one of the more useful ideas for understanding why markets can feel eerily calm one week and violently twitchy the next.

First, the plumbing: what a dealer actually does

An options contract gives its buyer a right — not an obligation — to buy or sell something at a set price. The seller (often a bank, called a "dealer" or "market-maker") collects a premium up front and takes on the obligation. To avoid being caught out, the dealer hedges by trading the underlying asset. The amount it needs to hold changes as the underlying price moves; that sensitivity is commonly called "delta." The rate at which delta itself changes is "gamma."

Gamma is where the story gets interesting. A dealer who is "short gamma" — typically because it sold options — must buy the underlying when prices rise and sell when prices fall, to stay hedged. That is momentum behaviour: it reinforces moves. A dealer who is "long gamma" does the reverse, buying weakness and selling strength, which leans against the market.

The dampening case, in plain sight

There is a clean real-world example in the equity index market. Research from the Bank for International Settlements looked at why the VIX — a widely followed gauge of expected S&P 500 volatility — stayed unusually low through much of 2023 despite plenty of genuine uncertainty. One explanation the authors found more plausible than the popular "same-day options" theory: the boom in yield-enhancing structured products.

When banks sell these products, they effectively buy an option from the client. To hedge, they buy the index when it falls and sell when it rises — a contrarian pattern the BIS described as "dynamic hedging." Dealers, in other words, became a stabilising force, leaning against price swings. As volatility fell, so did the cost of insuring against it, which fed the calmer conditions further.

It is a bit like a thermostat that keeps adjusting the room without anyone noticing. Nothing dramatic — until the setting changes.

When hedging amplifies instead

Flip the positioning and the same machinery works in reverse. If dealers are short gamma, their required hedges push them to chase the move rather than fade it. A modest rally forces buying; that buying lifts prices; that lifts delta again. The loop can intensify quickly, especially in thinner markets.

This is not a theoretical curiosity. The BIS has documented how electronic trading and automated strategies can widen liquidity gaps during stress, with market depth thinning right before sharp price swings. The mechanism is not that dealers are reckless — it is that hedging is a mechanical response to risk limits, and many participants respond to the same signal at once.

Why this matters for FX

Foreign exchange is the largest market on earth: average daily turnover reached $9.5 trillion in April 2025, up 27% from April 2022, according to the BIS Triennial Survey. And options are a fast-growing corner of it. Over-the-counter currency options turnover more than doubled between 2022 and 2025, from $303 billion to $634 billion a day.

The survey offers a striking clue about why. Options trading rose most in the currencies where hedging via forwards had become more expensive, suggesting investors were substituting one hedging tool for another. When US rates rose sharply from 2022, the cost of hedging dollar exposure climbed, and many institutions let their hedge ratios drift lower. Japanese life insurers, for instance, cut hedging rates from roughly 60% to 40%; Dutch pension funds slipped from 30% to 25%.

Then came April 2025. Tariff announcements and a sudden dollar depreciation jolted markets, and investors rushed to rebuild hedges. That showed up as a surge in forwards and options, with the BIS estimating the tariff news contributed about $1.5 trillion to turnover that month.

Notably, dealers largely absorbed the flow internally rather than dumping it into the market. Internalisation ratios — the share of client trades matched on a dealer's own books — ran above 80% across major trading hubs. That cushioned the impact. But the lesson stands: positioning shapes how much a given shock actually moves prices.

Crypto: same logic, different plumbing

Crypto options markets have grown quickly, and the dealer-hedging intuition carries over. Where a large options position sits, hedging flows can nudge spot prices around. Crypto trades around the clock, venues are fragmented, and data on who holds what is far less complete than in FX. So treat any specific claim about "gamma levels" in crypto with healthy scepticism — the framework is sound, the precision is often overstated.

What to take from all this

Dealer hedging is one lens among many. It does not predict direction, and it is not a signal. What it does offer is a way to think about why volatility can compress quietly, then expand sharply — and why the same market can feel steady and fragile in the same week.

It also explains why regulators and central banks watch market structure so closely. The BIS has repeatedly noted that less visible trading can support smooth functioning but may also obscure price discovery. Where that balance sits depends on jurisdiction, market and moment — and honest observers disagree.

For an ordinary investor, the practical takeaway is humility. Prices reflect not just opinions about value, but the mechanical needs of the institutions standing in the middle. Understanding that machinery won't tell you what happens next. It will, however, make the market's mood swings a little less mysterious — and, over chai, rather more interesting to discuss.