Hi Mark, really good article…
Have a couple of questions for you. [The questions were lengthy and so are the replies; it will take more than one post to reply to all. Stay tuned]
With regard to negative gamma. I know that you mentioned that
this is dangerous and risk increases as expiry gets closer – but don't the odds diminish, making the options you sold less likely to be reached?
This is the
trade-off but is it really that dangerous or is it relatively dangerous from a mathematical standpoint?
Certainly the odds diminish. You can see that in the diminishing price of the options.
Yes, it is a trade-off.
Yes, is really is that risky. From any standpoint, but especially from the only one that really matters – monetarily.
But it's important not to draw erroneous conclusions, and I'm not certain that you interpret my description of 'it's risky' correctly. I am not telling you to exit all positions prior to expiration.
What I have been saying is:
- It is far riskier to be short front-month options than other options. If you are willing to take that risk for the potential reward, that's an acceptable decision. All I am doing is warning you of the risk. I am not saying that you must (or even 'should') avoid that risk. That's your choice.
- Most traders, who have not yet been badly burned, love collecting time decay from expiring options.
- If your short options are reasonably far OTM, there is little chance they will run ITM. But, they are very inexpensive to cover, and I don't recommend trying to make those last couple of nickels. In fact, the position you describe should already have been covered. I buy those spreads early to exit the trade. Think in terms of risk and reward.
- If the short options are not too far OTM, then they always 'feel' too expensive to buy. All else being equal, the time premium in the option is half (with one week to go) of what it was with four weeks to go. When expiration is near, all most traders can see is the ticking clock and the wonderful positive theta. "If just one more day passes quietly, the position should make such and such."
They just 'know' these options are too costly to buy because when you sell time premium, your profit comes from time decay. It just feel wrong to buy back those options when time decay is approaching its maximum. But, it's not wrong.
The other question to consider is: What happens if the day doesn't pass quietly? What happens when the underlying moves 5%? At what point do you cover? How long would you wait? Some people, thinking only of what they could have paid yesterday, become frozen and do nothing.
From my perspective, I do not want to be in this position. And this can occur only when you are short the front-month options. It is a trade-off – and not every investor takes the same approach when managing positions.
- What many cannot see (or refuse to see) is the huge loss they will incur if the options suddenly run in the money.
When you are short the longer-term options, you also incur a loss when the options move in the money. But the loss is significantly smaller. Why? Because negative gamma is less for these options.
Think of the extreme case. Late in the afternoon on expiration Friday (the situation is similar, but different for index options because of the way the settlement price is calculated). One moment the delta is essentially zero. The stock moves a few pennies and the delta is now almost 100. That's the problem. These options achieve a very high delta – very quickly – and a subsequent move results in a major loss.
Longer-term options don't behave that way. On the 5% move described above, the delta may move from 50 to 60 or 65. That's not good, but it's far better than being short a 100 delta option when the underlying stock is quickly moving against you. And that only happens with options that have a short lifetime.