Negative Gamma. How much is enough?

Mark,
What values of gamma do you consider as high?


Cheers

John


Hi Mark,

When I am looking at my brokerage
account I have the same questions- what is considered high
(risky) Gamma and what is low (safe) amounts of negative Gamma.

Knowing
what you say about Gamma, is there a method of factoring in the effect it
has so that it is used to advantage when trading or adjusting?

Thanks,

Don

***

Gentlemen,

When using options, there are many strategies that a trader can adopt. Some come with positive gamma and positive curvature (risk graph = smile) and the trader makes money as the underlying makes significant moves.  One benefit that comes with these positions is the absence of tail (unlikely event) risk.  In fact, black swan events offer substantial rewards when the trader has both upside and downside curvature.

The cost of owning such positions is the daily time decay in the value of those options.

Examples

  • Buy calls or puts
  • Buy calls and puts (strangle, straddle)
  • Back spreads (more options are bought than sold)


Other strategies come with negative gamma, negative curvature (risk graph = frown), tail risk and positive time decay.  The trader who prefers this type of trade usually takes precaution against tail risk by owning positions with limited losses – i.e., no naked short options.  Nevertheless, a big market move is the enemy and the trader loses money when the underlying moves too far (or too fast).

Examples

  • Naked short options
  • Covered call writing
  • Credit spread*
  • Iron condor*

* Limited loss strategy


Delta represents the anticipated change in the price of an option when the underlying moves one point.

Gamma represents the anticipated change in delta when the underlying moves one point.  And gamma is not constant and also changes as the underlying changes.

When short (long) delta in a rising (falling) market you expect to lose money.  However, gamma makes it worse.  With negative gamma, delta accelerates and losses accrue more rapidly.

This is why I believe adjusting a trade to delta neutral is not good enough.  It's better to reduce gamma.  In other words, buying shares of the underlying doesn't do it for me.  I want to reduce negative gamma, and that means I elect to spend money on options when adjusting.

Another way to reduce negative gamma is to trade options that have less gamma.  Front-month options come with high gamma and high theta.  In other words, more risk and more reward.  To lower negative gamma, consider avoiding front-month options.

That brings us back to the question: When is gamma too high?

 'High" gamma does not necessarily have a 'number' associated with it. Look at it this way. You have a (premium selling) trade and it goes
against you. You adjust delta back towards zero.
Assume you are going to adjust again when the stock moves another X% or Y
points higher.

You will lose money on the move and be short more delta since the last adjustment. 
If you are short too many delta and if the loss is
larger than you are willing to accept between adjustments, then gamma is HIGH.
It means delta changed by too much.
Choices: Adjust sooner or reduce negative gamma.

Thus, 'high' is a relative term. Your comfort zone tells you when gamma is too high.  I cannot supply a number.

If you are trading a $5 stock, then the $4 call undergoes a huge delta change when he stock moves from 4 to 5.  Gamma is high.  If it's a $100 stock, delta does not change much when the stock moves from $99 to $100 and gamma is much smaller.  Thus, gamma is not the only risk factor to be considered.

Don, there's no method for using negative gamma to your advantage.  However, if you manage the position such that losses incurred due to adjustments are less than the gains from positive time decay, then negative gamma is not going to hurt.

745

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7 Responses to Negative Gamma. How much is enough?

  1. Don 07/21/2010 at 7:29 AM #

    Thank you Mark for that explanation, it is appreaciated!
    Don

  2. amit 07/21/2010 at 1:28 PM #

    Mark,
    Based on what I have learnt and thought about in past few days due to my trades: I would now only buy calls/puts in last month of expiry. The odds are more with us because of gamma. Is this thinking correct? The loss is guaranteed to premium paid, but the upside is huge. I would never buy otherwise because theta is your enemy. I am not sure what I would buy though, ATM or 2 levels OTM.
    Slightly off-topic: Based on looking at my trades, time decay is not linear. The more the underlying is at a particular strike, the more the time decay at that strike. Is the time decay calculated per day or week to week? The time decay graphs given in most literature outright gloss over the fact that those decay graphs are over an option which stays exactly ATM all the time. I am pondering over the shape of the true graph, when the spot price gyrates just below, much below, above, and much above the low strike I sold. Does that make sense?
    Thanks

  3. amit 07/21/2010 at 1:31 PM #

    Mark,
    I still won’t put any money in the last month going and buying calls/puts. I can’t tolerate the risk, look at the volume on weeklys though! Because I hate to waste on a gamble. I prefer slow developing trades.
    Thanks

  4. Mark Wolfinger 07/21/2010 at 1:51 PM #

    Amit,
    1) You are making ‘lifetime’ decisions – “I would now only…”
    You are FAR TOO INEXPERIENCED to do make these decisions.
    More on this tomorrow.
    Time decay is not linear. It is proportional to the square root of time.

  5. John 07/22/2010 at 5:24 AM #

    Mark, thanks for the post!

  6. Pierre 07/28/2010 at 1:34 AM #

    Mark,
    This is my first time visiting your blog so I want to ask as a beginner with learning options. What is the option or the kind of options investing that allows an investor to create a monthly return even if the market goes up or down? Is this a covered call? Which of your books would I learn more about this in? I will begin with the Rookie’s Guide, but could you elaborate on how it works?
    Thanks

  7. Mark Wolfinger 07/28/2010 at 9:02 AM #

    Hello Pierre,
    Welcome. There are a few different strategies that allow you to ‘earn an income, regardless of market direction.’ However, when people tell you that you CAN do that, they do not tell the whole truth and ignore the fact that there are complications.
    Some trades fail when the market moves higher. Others lose money when the market declines. Thus – although you can make money in any kind of market, you cannot blindly use those strategies.
    Covered calls have been shown to out-perform the markets over the long term, but do much better when the markets hold steady or rise.
    Selling call and/or put spreads is an excellent income-generating strategy. I use it all the time. HOWEVER, selling call spreads into a rising market can lose money. Selling put spreads into a falling market can also lose money.
    You can succeed with your plan. I strongly urge you to practice in a paper-trading account so you ca get a good feel for how these spreads work, including how to choose appropriate strike prices for your trades. There is no substitute for holding positions and watching them make/lose money to learn some valuable lessons. But by using a practice account, you can learn at no cost.
    You will find the Rookies Guide to be very helpful in explaining how these strategies work. Don’t bother with my other books becasue everything that suits your needs is in the Rookie’s Guide.
    I’d love to elaborate, but there is just so much to say. Do some reading and come back with specific questions.
    Take a look at my views here