Explosive Gamma

Addendum:  For anyone who doubts that near-term gamma can be explosive, today's trading ought to take care of those doubts.  DJIA was down 1,000 for a brief moment that rallied more than 700 points.


Previously posted at The Options Zone


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I often mention that owning a position with short near-term options is extra risky (with a correspondingly high reward potential) because negative gamma can wreak havoc on the position.   A recent email reaffirmed the notion that it's not enough to mention the problem with negative gamma.  It's necessary to offer more details, allowing everyone to understand the situation.

***

Mark,

In your book you make reference to
weekly options and I know people who are trading spreads and condors on those
options. As a beginner, I can see the advantage of a very short time exposure
to market change, but I can also see the disadvantage in the speed with which
you may have to carry out any position management.

What are you thoughts? Would you
recommend them?
For
example, what would you think about the SPX an SPX call iron condor: 

  • Shorts are each 50 points OTM
  • Cash credit =  allows for a 2% return ($50)
  • Expiration is
    Thursday
    of this week (today is Monday)
  • Very high probability of success?

I was very disappointed at how difficult is is to trade those weekly options.  Too little volume; bid ask spreads are too wide. I do NOT recommend trading iron condors or credit spreads with weeklies.

If you want a lot of bang for the buck; if you want high
risk and high reward position; then this fits the bill.  But it's too risky for my taste.

When little time
remains in the lifetime of an option, time decay is obviously very rapid. 
The problem is that you cannot collect much premium for selling these call and/or put spreads, unless they are not
far OTM.  When those options threaten to move ITM, gamma explodes and
losses mount quickly (more on explosive gamma below).  It's truly high risk/high reward.

If you believe you can manage those positions well, and if willing to take the
risk, they are viable to trade.  I want neither that risk nor reward.
But this is truly a personal decision. 

If you are new to iron condor trading, as you are, this is not a good situation to get your training.  I don't even like them in a paper trading account. You want to experience calmer conditions when learning to develop good risk management techniques.


Your example.  Margin is $2,500, so a 2% return is $50.
I am not willing to collect $50 when risking up to $2,450.  To do that, I want
very, very high probability of success.  More than 99%.  You may feel
differently, and that's fine.  But trying to collect these small premiums
month after month (or week after week) looks good and feels safe.  But it's
not. 

Ask yourself at what point would you cover out of fear or necessity.  How much would you lose in that scenario?  How often
would that happen? Then, how much profit remains for you?
Too dangerous in my book.  You don't win as often as you think –
because you will take losses to exit at least part of the time.

I did not look at the specific option deltas in your example.  Are you aware that adding the delta
of the short options gives you a good estimate of the chances that either
will finish in the money?  Total delta of 2 means 2% of the time. And if you are getting 50:1 odds when the true odds are 50:1, there's no advantage.

Comment:

Expiration is NOT Thursday.  This is a common misconception.  Expiration is Saturday, but what concerns you is Friday morning.  That's when the settlement price is determined for European options.  Please know how that price is calculated.  Novices frequently scream in anguish when they discover the rules.

***


NM continued:   I am not interested in high risk/high reward trades that lead to management under pressure. I will continue pursuing
a method based on monthly condors.

Would you make the same comments about the dangers of holding a one
month iron condor near to or up to expiration?  I don’t know the
reason for the explosion in gamma that you mentioned, so I don’t know if
it would apply to monthlies, but I can see that it should apply.

Is this the
reason that you tend to trade longer term condors and not hold them until near
the end of the expiration month?

NM

***

YES, that's the reason.  Current gamma – your position as it exists at the
time you look at it – is very dependent on the amount of time that
remains before expiration arrives.  It has nothing to do with how much time remained (prior to
expiration) when you opened the trade.  It's all about 'today.'

Correct.  It does apply to monthlies.

Longer-term options have less gamma.  Quick explanation:

Look at an
option with two months of lifetime remaining.  Assume it moves into the money.  Because there
is so much time remaining, it takes a huge move to get that delta up to
80 or 90. A 100 delta is seldom seen.  Reason: Because there is lots of time
for the market to turn around, and the probability that the option will be in the
money (that's one definition of delta) at expiration time is less – when compared with an
option with two days to go. 

Once that latter option is ITM, the chances
it will stay there are much higher – because there's less time for it to
retreat.  So delta explodes towards 100 quickly.  Thus, the option
moves point for point with the stock – and that means big losses. 

At
the other end, an option that seems to be safely OTM and has a delta near 5 can quickly move to 50 delta, as the
option becomes ATM.  With longer-term options, the delta
change (and gamma is the rate at which delta changes) is far less
dramatic.

The advantage to being short that explosive gamma is the rapid time decay.  In my opinion, that decay is not fast enough to justify the risk.  Many traders are very willing to take that risk for the reward.

682

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7 Responses to Explosive Gamma

  1. TR 05/06/2010 at 11:59 AM #

    Mark
    I have a question for you on rolling protective strangles as I am struggling to figure out what to do in my current situation.
    My current positions are as follows:
    12 LOT RUT Jun 630/640/780/790 IC
    12 LOT RUT Jul 620/630/790/800 IC
    1 LOT RUT May 660/740 Strangle
    My risk curve looks very comfortable to me right now but I am starting to wonder about rolling my May protective strangle into June. There are two competing forces I am dealing with and I could use your perspective to help me think through things:
    1) My May strangle has a higher theta than the Jun Strangle ( -57 for the May vs -44 for June) which makes me think that the I should roll to June right away and save myself $13/day in theta decay.
    2) My May strangle has a much lower vega than the Jun Strangle (Vega of 53 for May vs 131 for June) and I am of the opinion that volatility is high high right now so I may be better off waiting for volatility to drop before rolling.
    Another added thought I have is that perhaps I am violating my own principle of ambivalence on things like market direction & volatility. Maybe I should decide not to have an opinion that volatility is high and therefore I should roll now rather than wait. There is also the risk that the market can move in either direction making the roll of my strangle even more expensive.
    My apologies if this post is confusing. I would appreciate any thoughts and feedback you have.
    Rgds
    TR

  2. Mark Wolfinger 05/06/2010 at 12:37 PM #

    TR,
    Not confusing at all. But, this is a perpetual problem when long front-month options: Theta is bad, but gamma is good.
    To move to June costs real cash, unless you move father OTM.
    It’s awful to watch your May options fade away to nothing, but it’s not fun to own less gamma on a big move.
    With RUT tanking again (-14 as I write this), maybe you can find a good move to get rid of May – and it’s high and increasing IV and replace it with a reasonably priced Jun put. Yes, the June put has higher vega, but maybe (I did not look) the May IV is so much higher than June that selling it makes up for buying June vega.
    It really depends on just how much protection you want to own (the higher the put strike price, the better) and how much to pay to own that insurance.
    These are not easy answers. You are thinking correctly, but it’s never easy to make the decision.
    There’s cash at state here.
    There is one item: Even though I recommend the position you own, perhaps management of that position is just too difficult to make it practical.
    I wish I could offer a simple solution,

  3. TR 05/06/2010 at 1:19 PM #

    Thanks Mark
    I decided to make the roll of the strangle. You are right in that IV was higher for May vs June. I hadn’t thought of that. Thank you
    Rgds
    TR

  4. Rich 05/06/2010 at 4:15 PM #

    Mark, as you’ve said many times before, “Hope is not a strategy.” I closed out my IC when the short side hit my predefined delta and it certainly saved some bloodshed today. It was a small loss (and who doesn’t hate even small ones) but a necessary trade. How does one handle the psychological aspect of this if the market were to reverse itself after you’ve closed out the trade?

  5. Joe 05/06/2010 at 6:33 PM #

    Rich, I’ll tell you how one handles it. You pat yourself on the back for acting in the heat of the battle and imagine how much worse off you could’ve been. Mitigating catostrophic losses at the expense of potential profit is the choice I will always take.
    I know this question was directed to Mark but could’nt help but respond.

  6. Mark Wolfinger 05/06/2010 at 6:49 PM #

    Joe,
    Please feel free to jump in any time. I would love to see these comments become an open forum.
    Regards

  7. Mark Wolfinger 05/06/2010 at 7:02 PM #

    Rich,
    I agree with Joe. But I also have some comments on your question: The psychological aftermath.
    Look for reply tomorrow 5/7/2010