Long gamma trading options
On out of the money options, the gamma will start to decay, as those options lose their effectiveness. But as we approach options expiration, gamma drastically increases on at the money options.
This increase is what I affectionately term the "gamma knife edge," and it's where many new option traders get cut. Remember how I said gamma and theta were linked? Here's a chart of theta over time:. So not only do you have a significant increase in gamma, you also have a much larger amount of time decay in options. Funny things start happening to options as we approach expiration. The pricing models start to get a little weird, and you could potentially be taking on more risk than you thought-- regardless of whether you are an option buyer or seller.
Regardless of your trading style-- if you are a new options trader and just beginning to understand the mechanics of the options market, stay away from short term options. Opex trading and dancing around the gamma knife edge is a dark art that requires a level of agility that isn't often seen in new option traders.
Short Term Risks Many seasoned option traders will forego the riverboat casino that is options expiration and only trade options that have more than 2 weeks left to expiration.
This point leads me to the next principle new option trades should follow: Don't Trade Close to Expiration We'll dive a little further into option greeks so you can get a better understanding of what risks you take when trading short term.
The Gamma Knife Edge Gamma is a stock option greek that makes options trading so fun. It's also known as the second derivative, which doesn't mean much unless you are viewing a risk graph: Where It Gets Tricky The chart below shows the gamma of a call option buy, plotted over time: See the other side Remember how I said gamma and theta were linked?
Here's a chart of theta over time: The trading strategies of the desks to a large extent center around the gamma and the volatility exposures based on the market view they have. In this article we shall try to understand the gamma risks. While being long gamma requires funding costs i. So by being long gamma you would realize negative PnL on theta whereas positive PnL on theta by being short gamma [well almost always - one exception being long deep ITM puts are long theta].
One common practise is to be long gamma in trending markets and short gamma for ranged bound or sluggish markets. In the discussion that follows we assume that the portfolio is delta hedged at discrete intervals. Of course if we keep the portfolfolio continuously delta hedged, we would not realized any PnL [the argument assumes that the other risk factors do not change] i. It will be worth noticing in the discussion that follows how the perspectives of the risk managers and traders sometimes may be often differ.
Lets take the first scenario, the market is rallying stocks moving up. The traders would like to have long gamma exposures in such a market. With a long gamma exposure, as the markets rally the portfolio picks up more delta between rehedgings. To keep the portfolio delta hedged as the market moves up and the portfolio picks up positive delta, the trader will sell the stocks [or forwards]. With markets going up the trader is selling at a high [sell at a high while have bought at a low] thus making profits.
When the trader expects that the market will continue to rally, he would delta hedge less often to be able to accumulate more deltas [and hence more profits]. In another situation we suppose that the markets were crashing , the trader would again like a long gamma exposure. The portfolio would be picking up negative delta which the trader would cover by buying stocks [buying low] in a falling market.
The trader is making a profit in this situation by accumulating negative deltas on the way down.