How Market Makers Hedge SPX Options Exposure in Futures

SPX options trade about $1.2 trillion in notional daily, with about 75% of that expiring in a week or less. In comparison, US equity futures trade about $400 billion per day across the contracts cleared via CME.

The sheer magnititude of difference in notional values alone suggests that there is indeed price influence in ES (or S&P 500 e-mini futures) from SPX options hedging due to market makers attempting to neutralize their exposure.

How does this work? Market makers hedge their SPX options exposure, in part by using ES. Let's talk a little bit about how that works:

• In the context of options, delta represents the relationship between the option price and the underlying asset price. For instance, if an SPX call option has a delta of 0.5, it implies that for every $1 increase in the SPX value, the option's price would increase by approximately $0.50, assuming other factors remain constant.
  

• Calculating exposure: Market makers continuously buy and sell options linked to the S&P 500 index. They need to manage their overall delta exposure to prevent potential losses due to market movements. For example, if a market maker has sold more SPX call options than they have bought, they will have a positive delta exposure, meaning they could face losses if the SPX increases in value.
  

• Hedging with ES futures: To offset their delta exposure, market makers can buy or sell E-mini S&P 500 futures contracts (ES). Since ES futures closely track the SPX index, buying one ES contract will approximately offset the delta exposure of selling two SPX call options. This is because each ES contract corresponds to a notional value equivalent to 50 times the value of the underlying S&P 500 index. Therefore, buying one ES contract is roughly equivalent to buying the delta exposure of two SPX call options.
  

• Dynamic hedging: Market makers continuously monitor their delta exposure and adjust their positions in ES futures accordingly. This dynamic process allows them to maintain a balanced portfolio and minimize risk associated with changes in the SPX value. For example, if the market maker's delta exposure increases due to changes in the market conditions, they would buy more ES contracts to offset this increased risk.
  

• Re-balancing: Market makers must rebalance their hedges periodically as the delta exposure changes due to factors like option expiration, changes in implied volatility, and shifts in market sentiment. This ongoing process ensures that market makers can effectively manage their risks associated with SPX trading while maintaining a balanced portfolio.

In a nutshell, SPX options trading can and does have an impact on price discovery in ES futures, it's a phenomenon that we see daily and we will be providing more documentation and analysis of this as time goes on.