Positive Gamma

In previous posts, I've discussed buying insurance when your option portfolio is subject to losses resulting from a significant market move.

As a seller of credit spreads (the two halves of an iron condor position), I often own such insurance.

I thought this would be a good time to mention that those insurance strategies can be used as a standalone position with positive gamma.  In other words, if you want to own a position that earns a profit when the market makes a quick and large move, either of those insurance positions can work for you.

The first is a simple plan: buy puts and calls.  I am not a big fan of this play. Primarily because it costs too much (for my comfort).  But, if the unexpected big move does occur, the payoff can be substantial.

The play I prefer is the credit spread, with extras.  The initial cost is low and if nothing wonderful happens, the final cost will depend on how you handle the leftover part of the trade (when your long options expire).  You can find more information in the example discussed earlier.

That example: 

   Sell 3 (or a multiple thereof) RUT Apt 360/370 put spreads
   Buy 1 (for each 3 spreads above) RUT Mar 360 puts

If the market heads lower, you own naked long puts and that's why profits are available when the market drops.

Addendum 7:15 AM 2/18/2009

If this appeals to you, be certain to choose options that give you a chance to make some money.  The two major factors to consider are: the strike prices and the ratio of extra longs to short spreads. 

When using this idea to insure your portfolio, it's easier to choose strikes because you want the potential profit from this position to occur before the underlying reaches a price at which losses become unacceptable.

248

4 Responses to Positive Gamma

  1. James Y. 02/18/2009 at 8:48 AM #

    Hi Mark, I appreciate your blog, it’s been very helpful.
    I’m trying to understand selling Naked Puts. It is not very clear to me, how the mechanic of this action works.
    I got that I don’t have to own the stock to open contract to sale, if stock trade at $200 and I open contract to sale it at $100 and the premium is $3.00 I get that. And if the stock drops to the $100 then now I own it….is that correct..? ok…
    Then once I open this position that I want the stock to go up, and that is what I don’t get, why…? How that this work? Can you explain the logic or the mechanics of how I profit from it going up…
    Also if I got this right, then I can lowball stocks that I like to have if they ever get to certain low price, and most likely will not, and keep getting premiums for doing just that…?
    I hope this isn’t too much to ask!
    James

  2. Mark Wolfinger 02/18/2009 at 9:03 AM #

    Hello James,
    1) If the stock is $200, it’s not likely that anyone will want to buy a put option that gives them the right to sell stock at $100. But, for the purposes of this discussion, let’s agree that you can sell this put and collect $3.00 (or $300 cash).
    2) No. If the stock drops to $100, you do NOT own it. The put owner has the right to exercise the option, but he/she is not obligated to do so. In fact, it is very unlikely that anyone would exercise that option prior to the option’s expiration date.
    Thus, it would be correct to say: If the stock is below $100 (the strike price) at the time that expiration day arrives, then you would own the stock because the option owner exercises the option.
    3) Once you own the stock, do you really not understand why you want the stock to move higher? Anytime you own stock, you make money when its price increases and lose money when the price deceases.
    The fact that you bought this stock by being assigned an exercise notice on a put option changes nothing. When you sell a put option, you accept the obligation to buy stock. Many times the option expires and you do not buy stock. But when you do buy it, you own it – just the same as anyone else who owns it. If the price moves higher, you make money.
    Yes. You can sell put options on stocks you would like to own – if they reach a certain price level (the strike price). That is a good reason for selling naked put options – the willingness to buy stock at prices that are (currently) below the market price.
    Yes. You can collect the premiums over and over.
    But, this is not free money. Sometimes markets crash and you could find yourself owning a lot more stock than you want to own. So, when you use this strategy, please don’t sell too many puts. If you want to buy 800 shares of a given stock, please sell no more than 8 puts at one time.
    No, it’s not too much. It’s important to ask questions when you don’t understand something.

  3. inkblue 02/18/2009 at 9:35 AM #

    I took your advice and bought an ATM long put as insurance for my iron condors. The market has fallen quite a bit, and now the insurance put has doubled in value. My iron condors are still within a comfortable range for me. However, I’m stuck in this weird situation where my insurance put is so huge they negate my gains from the iron condors. Do you have any advice has to how I should fix this situation? Maybe add more iron condor or sell something off?

  4. Mark Wolfinger 02/18/2009 at 9:41 AM #

    1) Sell insurance. Use profits to pay to close some put spreads. For example, if you made $1,000, buy three put spreads @ 3.30.
    2) Roll insurance. Sell your longs, buy a lower strike. Bring in some cash and still own protection.
    3) Diagonalize insurance. Sell out Febs and buy March.
    4) Adding more IC is ok – but you may not want to hold the very expensive puts and longer. Adding IC should be a separate decision.