Mulligan Please

Did late summer and fall of 2011 leave you and your portfolio confused by the market’s prolonged period of elevated price volatility and seemingly inconsistent day-to-day price action driven by a constant barrage of surprise credit market drivers emanating out of Europe? If you answered a reasonable “yes”, you’re not alone. It’s also likely those daily gyrations may have proved costly. But during this same time period, did you know the opportunity to have gamma scalped the market using a long curve option or smiley face option structure could have enabled you to enjoy profits like many professional and /or option-savvy traders did?

We believe this to be true and it’s less difficult to trade a market in this capacity than you might think too. By taking the time to understand the mechanics of gamma and its impact on the more well-known directional Greek known as delta, as well as learning how to position confidently for price volatility through an option’s vega component; the potential for increased profitability and less guesswork tied to the stock chart could be part of your trading methodology moving forward.

In the following two part piece, we’ll examine the nuts and bolts of the gamma scalping strategy. We’ll then apply this strategy foundation to a basic long straddle position in the SP-500 ETF (SPY) during the second half of 2011 and walk readers through one simple, yet possible series of adjustments or scalps. Our desire is to help you come away with a more thorough understanding of this type positioning, the risks and rewards involved, as well as the trade-offs, when decisions to scalp and how to scalp one’s gamma are determined.

Delta Meet Gamma

So, what exactly is gamma scalping? Gamma scalping is the application of hedging deltas manufactured by the Greek gamma over the course of a directional move in an underlying security. A standard position suitable for gamma scalping is the long straddle. The long straddle can be designed with either a combination of long calls and long puts or synthetically using long stock and long puts ratio’ed together or short stock and long calls.

Gamma is the rate at which an option or a spread’s delta changes over the course of a one point move, up or down. Long call and long put positions are long gamma. At-the-money, near-term contracts possess the most gamma per point as the 50 delta is much more reactive to movement in the underlying. Unlike a contract with months until expiration, this type contract will finish in-the-money and have an equivalent stock delta of 1 for calls or -1 for a long put, or out-of-the-money and a zero delta, without requiring a large move from the underlying. In fact, right at expiration it takes but a couple pennies to move a contract from zero delta to a stock equivalent 1 or -1 or 100 or -100 deltas based on one contract representing 100 shares.

Left unattended during a rally or decline in the underlying product, a flat delta, long gamma position such as the long straddle builds up a delta bias in sympathy with the move witnessed. This is called having long curvature by many. On the risk graph this characteristic of positive deltas increasing on rallies and negative deltas being manufactured on declines has the shape of a smile; thus it’s also referred to as a smiley face position.

Figure 1: Long Straddle SP-500 (SPY) 10 x October 120 Strike. The risk graph reflects an at-the-money straddle purchase on August 17, 2011 for just more than $10.00 per spread. Notice as time passes and if shares of SPY remain at the bought 122 strike, the entire premium is wiped out. This risk can be managed through gamma scalping when the curve or smile is working for the position.

Beware Greek Tragedies

The initial smile shape of a long straddle, though friendly to a strong price trend which emerges in shares after its purchase, does come with a cost. That cost is the premium paid for the position which can be completely exhausted by expiration due to daily time decay known as theta. During the term of the straddle, lower implied volatility being priced in by traders in the open market can also act as drag on the price of the straddle if it remains composed primarily of or entirely of extrinsic value.

Lower implied volatility is a threat due to the long straddle’s other Greek risk known as vega. The vega component measures the shift in premium of a contract based on a one point move in vega, up or down. Because of the purchased call and put contracts, the straddle is long vega or volatility. Hence the spread will see its market price drop if implieds decline due to reduced investor interest in owning protection via long calls or puts and / or lesser statistical or underlying volatility applying pressure on implied volatility readings.

Knowing of these potential Greek risks with the straddle, a trader can look to keep ‘smiling’ and try to grow their profits by scalping gamma i.e. the act of hedging or neutralizing the position’s delta risk as it builds up. For instance, after a meaningful rally turns a straddle’s flat delta into a position with +300 deltas due to the long gamma, a trader would look to sell short or negative deltas of -300 in order to flatten out the directional risk.

The use of hedging the built up deltas with stock is the most popular and simple method to flatten out the delta risk. However, traders should look to the option market for potential increased theoretical edge such as selling deltas with a short call transaction if implieds spike higher or buying puts if premiums are cheap. However, unlike stock which maintains no Greeks other than a constant delta of 1, those choices will change the risk structure beyond the scope of this basic introduction to gamma scalping.

Now let’s assume the underlying drops aggressively shortly after initiating the stock sale. From a flat delta position composed of the long straddle and the shorted stock, an accumulated net short delta that’s built up during the move lower can be flattened by purchasing back shares for a profitable scalp. If the underlying makes a series of up, down, up, down movements and the trader hedges each of those moves by selling shares, then buying, selling and then buying again to flatten the accumulated delta with each of these price swings, the process results in a series of profitable scalps.

If enough profitable scalps are performed over the life of the position and beyond what has been lost of the straddle’s value during that same period of time due to time decay and / or lower implieds; the trader pockets that difference. At the end of the day, week or month; what these gamma scalps, or “delta adjustments” look like are highly unique to the trader. Ultimately, the decision as to how much a the trader will allow a delta to build or accumulate before hedging is a personal risk preference, but one typically driven by technical expectations and / or more theoretical considerations such as keeping one’s daily theta or time decay risk to an acceptable level.

In Part II we’ll dig a bit deeper into gamma scalping by illustrating a series of adjustments using extremes in the CBOE Volatility Index ($VIX). See you then.

Chris Tyler
Senior Options Writer, former Market Maker & fulltime Option Hedge Hog Advocate
Optionetics.com ~ Your Options Education Site
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The information offered here is based upon Christopher Tyler’s observations and strictly intended for educational purposes only, the use of which is the responsibility of the individual.