I heard a good joke today. It goes like this:
Doltie: “Knock Knock”
Trader: “Who's there...”
Doltie: “Gamma Scalping”
Trader: “Gamma Scalping Who?”
Doltie: “Gamma Scalping Doesn't Work Anymore...blah blah, ha ha”
When I have students come up to me on the message boards or in person and tell me they have heard a particular strategies doesn't work anymore, the first thing that comes to mind is either:
- They are doing it wrong, or
- The person they are getting their information from is upside down.
The sad thing is that many people get advice from people they deem as being brighter about trading than themselves, which is how we all learn and is valuable. The problem is that the people giving advice don't always know when to admit they don't know something or may be wrong themselves.
Like ALL trading strategies there is a time and place for it. And if gamma scalping isn't working then reverse gamma scalping, by definition, will be working. To say gamma scalping doesn't work because you had a bad trade with it is akin to saying that condoms don't work because you know someone who got pregnant using one. The person commenting obviously has a remedial understanding of both concepts.
Gamma Scalping Defined
Gamma Scalping is the strategy by which a trader takes his positive gamma and trades stock (futures, combos or options) around the deltas (both positive and negative) the position acquires after the underlying moves and the position's delta changes. By trading the deltas one is proactively making an attempt to profit from the stock movement in either direction.
Suppose someone buys a straddle in a stock or an index which results in a long gamma scenario. You have the position on one month only to realize that time decay (theta) is your enemy. It is not uncommon for a stock or index to make a big move one day, only for the underlying to go back to the original starting point a day or two later.
Suppose the Dow fell 300 points one day when you are long a straddle? You immediately begin to see a profit and start dreaming of the car you are going to purchase with the profits. Then the next day the market bounces back 200 points and another 100 points the following day. In short, the profits you made the first day were wiped out the second and third day with the Dow going back to the starting point. Even worse, you may have lost a little because of time decay.
When you buy a straddle you are hoping for a big move and then after you get it the stock doesn’t move and you don't make any money. This is a very frustrating situation to be in. Anyone who is married knows the frustration of being right and wrong at the same time. Solution: when the stock is down you buy stock (or other long deltas) to get yourself delta neutral in case of a bounce back up. The result is that you have locked in some of that profit. If the stock/index continues to fall you will likely still make enough money on the straddle to more than compensate for the long stock loss. If the market bounces back up, then you will make money on the long stock even if the straddle gives back the profits. In other words, gamma scalping forces you to be a genius day trader as you can't trade deltas wrong. The worst you can do is buy (or sell) deltas to neutralize your position too early.
Case and Point
Suppose on 6-27-06 you elected to purchase the DJX 110 straddle because the stock was exactly at 110. You had a feeling the market was going to move, but you didn't know if it was going to go above 110 (Dow 11,000) or below, but you believed it was going one way or the other.
You purchase the straddle for $3.00 which is delta neutral at the time. At the end of the day you see that the market is closing at 109.25. You look and see your position now has a delta as follows:
Figure1: Delta Position
You are short a little over 300 deltas so on the close you go and purchase 300 DJX ETFs at 109.25.
A couple days later the Feds raise interest rates and the market goes up of all things. Had you left the position alone all the money you made on the way down would have been given back on the way up.
Today (6-29-06) the market is closing at $111.91. What does the position look like? Well the straddle is trading at roughly $3.20 resulting in only a profit of $0.20. Why did you make only $0.20 on your straddles after all that movement. First, time decay eroded some of the profits you made on the stock movement, but.... Second, you lost some money due to volatility coming declining after the bounce. The VIX fell from a 16% to a 13% due to fear subsiding from the marketplace.
Yes, you did make money on the delta and gamma of the straddle in terms of those greeks, but two other greeks (theta and vega) gave a lot back. This is the frustration people who only trade straddles sometimes feel. They are right (about movement and opinion) but wrong (about profits) at the same time.
Figure 2: Sell Position
Gamma Scalp Position
For those who gamma scalped (instead of just bought the straddle) you had an extra profit from when you bought shares at $109.25 which can now be sold at $111.91 which is the goal of gamma scalping. You made $2.66 (111.91 – 109.25 share sale and purchase respectively) on top of the $0.20 from the straddle. Because you had 300 shares of DJX and rode the shares $2.66 you profited an extra $800.
This example is a very small time frame and during the last few days. I also had volatility working against me. In other words, this was not the best example by any means to illustrate my point. I could have cherry picked and found a home run, but that would have been biased and made me guilty of the same ignorance I am trying to dispel.
Gamma scalping is by no means dead. It is a hammer that has a time and place in your tool box of trades in the same way that the screw drive of time spreads and the wrench of vertical spreads does. Use any tool the wrong way and the house will not be square. This article is by no means a do-it-yourself article on how to properly gamma scalp as it is a detailed strategy that requires more attention than can be given in 1,000 words. To learn more about this consider taking an advanced course and have your instructor explain the details to you. Keep learning and keep pushing yourself. You will get out what you put in.
Staff Writer and Trading Strategist
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