Q & A Gamma Scalping

Dear Mark,

Could you explain something about gamma scalping?
I've read it's a way to complement the iron condor strategy.

Regards from Spain.
Gamma

A.
***
Hello A,

The discussion that follows is on a more advanced topic and not specifically directed to rookies. Gamma scalping is not used by the vast majority of individual investors, but is used continuously by professionals.

Let me begin by saying that gamma scalping is a method to take advantage of a position that has positive gamma.  It allows you to sell into rallies and buy on declines – and reduce risk (by returning to a market neutral position) at the same time.

The idea is to 'scalp' stock – i.e., to buy stock at a lower price and sell at a higher price.  Obviously, the stock must move up and down for scalping to work efficiently.

I'll define the necessary terminology below for rookies who are unfamiliar with the language of options.  But first, I must tell you that this methodology is not appropriate for buyers of iron condors because such positions have negative gamma. 

When you own an iron condor (short one call spread and short one put spread) your position gets longer when the market falls and shorter when it rises.  Thus, if you sell rallies and buy dips, you are adding to your risk – and the purpose of gamma scalping is to take some profits while reducing risk.

Definitions

When the term is used by day-traders, scalp means buying and selling while seeking relatively small gains.  When used with an option position, scalping refers to the technique of buying delta (buy stock, buy calls, or sell puts) when the stock declines and doing the opposite (sell stock, sell calls, or buy puts) on rallies. 

Scalping with option positions is seldom done for small gains.  While there is often no specific profit target per scalp, the scalper usually makes an adjustment at predetermined levels.  One method is to trade every time the stock moves 'x' points.  More sophisticated traders adjust when the stock moves one (or two) standard deviations. [S * V * SQRT (t)]

S = Stock price (underlying price)

V = Volatility (0.30 is used when volatility = 30)

t = time.  The number of YEARS before expiration. Use 1/252 for one day because there are 252 trading days in one year

Thus; $60 stock, volatility of 35% and a time period of two days gives us a standard deviation of:

$60 * 0.35 * SQRT (2/252); or 1.87 = one Std Dev

Delta is the rate at which the value of an option changes. By definition, it's the change in the value of an option (put or call) when the underlying asset (stock, index, or ETF) moves by one point.  Calls have a + delta (0 to 100) and puts have – delta (0 to -100).  Delta is not a constant number and changes as the stock price changes.

Thus, if a stock has a delta of 0.30, you can expect the price of a call option to be $0.30 cents (per share, or $30 for the value of one option contract) higher when the stock rises by one point and $0.30 lower when the stock falls by one point. NOTE:  Other factors (passage of time, implied volatility etc) come into play when pricing options – and the delta is merely one factor that allows you make a good estimate of how an option will be priced when the stock price changes.

Assume you own 10 of these '30-delta' calls and the stock declines by five points (delta moves from 0.32 to 0.27).  Your 10 calls contributed 320 long delta to your position, but now contribute only 270 delta.  If you buy 50 shares, your position becomes neutral again.

When you own a position consisting of more than one option, then you must add the delta of each option owned and subtract the delta of each option sold.  Remember, owning puts gives you negative delta and selling puts provides positive delta.

The idea behind scalping is to return to owning a delta neutral position. 

Gamma represents the change in delta when the underlying changes by one point.  Gamma is a positive number and has the same value for a call and it's corresponding put (same stock, same strike, same expiration).

Thus, if a call has a .45 delta when the stock is priced at $63 and a .42 delta when the stock price changes to $62, then the gamma is 0.03.  

It's gamma that allows you to make these scalping trades.  If delta were constant, you would not be getting longer on rallies and would not have deltas (in the form of stock) to sell.  Thus, it's appropriate to refer to this idea as 'gamma scalping.'

When you have positive gamma, you almost always have negative theta.  That means the value of your options decreases as time passes.  One goal of gamma scalping to to earn more than you lose in time decay.  Positive gamma looks nice in a risk graph because the graph shows a profit when the stock moves up or down.  But, time is the enemy and if the position is not closed before too much time elapses, you are going to lose money.  These scalps are an effort to earn profits by taking advantage of those ups and down moves.

Mark

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One Response to Q & A Gamma Scalping

  1. Tor Brox 05/23/2012 at 4:07 AM #

    Hello,

    Interesting article on

    Gamma scalping;

    I’m trying to simulate a position in the OMXS
    Trading at 1002 yesterday.

    Delta neutral position with Future at 1002;
    Long 100 puts (delta 0,48) with strike price 1000.
    Long 48 futures.

    a)The index rallies 20 points and I can sell 12 futures
    at 1022 (delta 0.36)in orther to get a delta nutral position. (The value of my 100 puts are now 16,50)

    How much have I made?
    SEK 24.000,-.?

    b) The future comes back down 20 points to 1002 and I buy back the 12 futures sold at 1022 in order to get a delta neutral position.
    Have I then made another SEK 24.000,- or nothing on this last trade?

    What is the total profit on a + b, all done in the same day.

    If the market keeps on going up and down like this will the position make SEK 24.000 or SEK 48.000 on each round trip?

    Thanks
    Tor

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