Got Vol? Trade Around It.

Find yourself trading the same strategies over and over? Sometimes mixing things up and learning about other strategies doesn’t hurt. Take straddles for example. There are times when an option looks like a buy—not from a directional standpoint but in terms of volatility (vol). The stock may have been fluctuating, and you think it’s priced cheap relative to its historical vol and daily price moves. So, you might want to get long vega by buying an at-the-money (ATM) straddle. You’d choose the ATM strike because it’s the point of maximum vega, plus it’s delta-neutral—the 0.50 delta from the ATM call is offset by the put’s -0.50 delta.

Yet, buying and holding a straddle is risky. Not only do you have the vega risk— just because vol is low doesn’t mean it can’t go even lower—but you’ve also got time working against you in the form of theta, i.e., time decay.

The theoretical value (TV) of an option is based in part on how much the price of the underlying stock is likely to move between now and expiration. The less time left until expiration—theoretically, anyway—the less opportunity for movement. So all things being equal, the price of a long option loses value with each tick of the clock.

When you sell an option, theta acts as a strategy tailwind. But with long options, it’s the opposite. So for that long ATM straddle, the negative-theta meter starts running once you place the trade.

But there’s a positive side to negative theta: gamma. And if you’re long an ATM straddle in anticipation of a vol spike, gamma might be the key to help offset a theta drag while you wait.

The Gamma/Theta Trade-Off

When stock prices move, options prices also move by an amount roughly equivalent to the delta. So if a call option has a 0.50 delta, a $1 rise in stock XYZ would theoretically raise its value by $0.50. But here’s the kicker—as XYZ rallies, so does its delta by an amount known as its gamma. In other words, gamma can magnify the effects of the underlying stock movement on the price of an option (see table 1).

As XYZ moves from $60 to $61, the 60-strike call’s TV increases by $0.55, which is a bit more than its 0.50 delta would suggest. It may help to consider delta over a range instead of a single point. So, from $60 to $61 in the underlying, the average delta is (0.60 - 0.50)/2 = 0.55.

Because of gamma, as XYZ rallies, the call’s TV rises at a faster rate until it becomes a deep in-the-money (ITM) call, with a delta approaching 1.0 until it moves virtually 1:1 with the stock price. And if the stock price drops, the delta decreases as well. Although the call option drops in value as the strike moves further out of the money (OTM), it does so at a slower and slower rate until, at some point, its delta is virtually zero.

The same holds true for put options. If you’re long an ATM put and the stock goes down, the TV of the option increases at an increasing rate. If the stock goes up, the put’s TV decreases at a decreasing rate. That’s the power of gamma.

But gamma isn’t free. To be long gamma is to be long options, which means negative theta. At any snapshot in time, gamma augments delta and thus TV. But with each passing moment, theta is pushing TV the other way. With options, there’s always a trade-off.

Not Just for the Big Players Anymore

Until recently, gamma scalping wasn’t a popular strategy among smaller retail traders. To consistently get that “hedge-able” quantity of shares for your gamma scalp, you might’ve had to take on too large of a position size, or widen your entry and exit points. Otherwise, commission costs would’ve likely eaten into the net profit per scalp.

Trading the Gamma

Going back to table 1, suppose you bought five of the 60-strike straddles for $4 each.

Consider this scenario: Suppose that after you bought the straddles, XYZ dropped to $59, but then rallied back to $60 by the end of the day. The TV would’ve risen from $4 to $4.10 and then likely fallen back to $4. But now that it’s the end of the day, all things being equal, that negative theta kicks in, dropping TV by $0.06 per option, or $60. (Remember, it’s five calls and five puts times the multiplier of 100.)

What if you’d bought 100 shares of XYZ when it was down at $59? After all, it wasn’t just the TV that changed when the stock broke; the deltas changed as well—the call from 0.50 to 0.40 and the put from 0.50 to 0.60. Combine them, and that’s a 0.20 delta times the five straddles, or 1.00 deltas.

You could’ve bought 100 shares of XYZ to maintain a delta-neutral position. And when XYZ moved back to $60, you could’ve sold the 100 shares you bought, returning again to delta-neutral but with a $100 “gamma trade” in your pocket (minus, of course, the day’s theoretical time decay of $60 and any transaction costs you may have incurred).

How do you decide where to place your entry and exit points? There are no hard-and-fast rules, but let’s review three ideas.

Dollars to cover. In our example, with a theta of 0.06, this position theoretically loses $60 overnight. So that becomes the hurdle. If you can average at least $60 per day in gamma trades, you can buy yourself some time while you wait for the vega move you’re expecting.

Pair with a technical analysis strategy. If you typically trade technicals, you might use them to help guide your entry and exit points. For example, as XYZ moves in the direction of the primary trend, you might hedge only a portion of your delta and let the rest run. Or, if you near a support or resistance level, you could pick a point just shy of it and flatten your delta.

Trade the standard deviation. Volatility and thus options prices are derived from probabilities of price movement. Without getting too geeky, vol is essentially a measure of annualized standard deviation. So, many dynamic gamma hedgers use the daily standard deviation as a place to square up their deltas. But you don’t need to calculate it yourself. The thinkorswim® platform can do it for you (see figure 1).

Know the Ground Rules and Limitations

This strategy is neither for the fainthearted nor the casual participant. You can’t just set it and forget it. And because this strategy touches on all the major greeks—delta, gamma, theta, and vega—there are lots of moving parts.

Remember that no greek is constant. As you approach expiration, that theta number gets bigger, and so does the gamma number. At expiration, each option is either ITM or OTM. It’s either worth its intrinsic value and exercised, or it expires worthless. So the stakes get higher the closer you get to expiration. Even veteran gamma scalpers may liquidate or attempt to roll their positions before expiration.

Besides, if you’re trading gamma as part of a long vega strategy, you’ll likely want to move on well before expiration. Theta and gamma intensify as you approach expiration, but vega decreases.

Speaking of long vol, some traders like to let their deltas run a bit more on the upside (and tighten them on the downside), because vol tends to drift downward on market rallies and drift upward as markets break.

Gamma trading is a complex strategy, but one that can help you get in tune with the interplay among all those greeks. If you can master it, you might develop a deeper understanding of how options prices move. If you’re used to trading options from the short side, dynamically hedging around a long options position might broaden your perspective.

In today’s online zero-commission environment, you don’t need the big guns to be a gamma trader. You can start small with a few contracts per trade. Want to go even smaller? Fire up the paperMoney® platform and gamma scalp risk-free for a few expiration cycles until you get the hang of it.