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Why You Should Not Ignore Negative Gamma


Iron Condor is a very popular strategy used by many traders and investment newsletters. There are many variables to the Iron Condor strategy. One of the most important ones is time to expiration of the options you use. The time to expiration will impact all the Greeks: the theta, the vega and the gamma. 

In this article, I would like to show how the gamma of the trade is impacted by the time to expiration.

For those of you less familiar with the Options Greeks:

 

The option's gamma is a measure of the rate of change of its delta. The gamma of an option is expressed as a percentage and reflects the change in the delta in response to a one point movement of the underlying stock price.

 

This might sound complicated, but in simple terms, the gamma is the option's sensitivity to changes in the underlying price. In other words, the higher the gamma, the more sensitive the options price is to the changes in the underlying price.

 

When you buy options, the trade has a positive gamma - the gamma is your friend. When you sell options, the trade has a negative gamma - the gamma is your enemy. Since Iron Condor is an options selling strategy, the trade has a negative gamma. The closer we are to expiration, the higher is the gamma.

 

Lets demonstrate how big move in the underlying price can impact the trade, using two RUT trades opened on Friday March 21, 2014. RUT was trading at 1205.

 

The first trade was opened using weekly options expiring the next week:

  • Sell March 28 1230 call
  • Buy March 28 1240 call
  • Sell March 28 1160 put
  • Buy March 28 1150 put

 

This is the risk profile of the trade:

 

0292e6d2639d912cde730a1a25907a13.png

 

As we can see, the profit potential of the trade is 14%. Not bad for one week of holding.

 

The second trade was opened using the monthly options expiring in May:

 

  • Sell May 16 1290 call
  • Buy May 16 1300 call
  • Sell May 16 1080 put
  • Buy May 16 1070 put

 

This is the risk profile of the trade:

 

1b73694562cae3b538a471657e7b919d.png

 

The profit potential of that trade is 23% in 56 days.

 

And now let me ask you a question:

 

What is better: 14% in 7 days or 23% in 56 days?

 

The answer is pretty obvious, isn't it? If you make 14% in 7 days and can repeat it week after week, you will make much more than 23% in 56 days, right? Well, the big question is: CAN you repeat it week after week?

 

Lets see how those two trades performed few days later.

 

This is the risk profile of the first trade on Wednesday next week:

 

13285d3425bffc41fa73e2bca6d4d69b.png

 

RUT moved 50 points and our weekly trade is down 45%. Ouch..

 

The second trade performed much better:

 

cbbeec2448210c846db29ca850cae6ca.png

 

It is actually down only 1%.

 

The lesson from those two trades:

 

Going with close expiration will give you larger theta per day. But there is a catch. Less time to expiration equals larger negative gamma. That means that a sharp move of the underlying will cause much larger loss. So if the underlying doesn't move, then theta will kick off and you will just earn money with every passing day. But if it does move, the loss will become very large very quickly. Another disadvantage of close expiration is that in order to get decent credit, you will have to choose strikes much closer to the underlying.

 

As we know, there are no free lunches in the stock market. Everything comes with a price. When the markets don't move, trading close expiration might seem like a genius move. The markets will look like an ATM machine for few weeks or even months. But when a big move comes, it will wipe out months of gains. If the markets gap, there is nothing you can do to prevent a large loss.

 

Does it mean you should not trade weekly options? Not at all. They can still bring nice gains and diversification to your options portfolio. But you should treat them as speculative trades, and allocate the funds accordingly. Many options "gurus" describe those weekly trades as "conservative" strategy. Nothing can be further from the truth.

 

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Kim,

 

Correct me if I'm wrong but the second trade will become as risky of the 1st trade the close one gets to expiration? Besides, the gamma may be smaller for the 2nd trade but one has to hold the position longer which exposes us more market fluctuations. 

 

Hence, on the long run, is there any money to be made with iron condors?

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You are correct. This is why I usually don't advocate to hold till expiration. I prefer to enter 5-7 weeks before expiration and exit 1-2 weeks before expiration. Let someone else to collect the last few nickels.

 

I believe that iron condors can be profitable in the long run if managed correctly. That means limiting the losses in the losing months and not holding till expiration to reduce the gamma risk.

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hi Kim

 

Very useful post !! thanks!

 

 I prefer to enter 5-7 weeks before expiration and exit 1-2 weeks before expiration.

 

If you entering this trade 5 weeks before expiration, arent there more chances that it might break away and trade outside the boundary exercises prices (the limited profit strike range).

 

exit 1-2 weeks before expiration.

On the contrary, if you enter 1-2 weeks before expiration and exit just before (3 days) expiration, the probability of breaking away is less and you might also avoid the -ve gamma risk.

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Correct, but when you enter 1-2 weeks before expiration, your profit zone is also narrower. Take a look at the two examples. In the first example, the breakeven points are only 2-3% away. In the second example, your breakeven points are 8-9% away. When you use the same deltas, your probability to go ITM is similar in both cases.

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What is better: 14% in 7 days or 23% in 56 days?

 

Assuming enough occurrences,Probability  and theoretical payoff wise  it would always be more profitable  to choose the shorter duration despite your caveats about gamma.

 

The real killer is the 800%   commission cost for the weekly strategy. Even if you do outperform the equivalent 56 day strategy, you might ponder if  you're not just assuming all the risks and handing all the  theoretical profits over to your broker. 

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Even if this is true (which I'm not sure), the real problem is the drawdowns. With weekly options, occasional 50% losses is inevitable due to high negative gamma. And if you make 5%/week 10 weeks and then lose 50%, you are not back to even. You are down 20%. This assuming that 50% loss came after ten 5% winners. What if it comes after two winners?

 

Due to significantly higher potential loss, you should allocate much smaller position to weekly trades, which means that total return will be lower even if the average return is higher over time.

 

There is always tradeoff between risk and reward. Higher reward = higher potential risk = smaller allocation = smaller total return. 

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Working to come up to speed ...

1) Would you consider something like selling a vertical put spread gamma negative?  Or is that then direction dependent, i.e. you're "happy" (friend) if the underlying goes up, and "sad" (enemy) if it goes down.  So are you referring to when you don't want the underlying to change at all, or in this bull put spread case also?

2) Is an iron condor (initial setup) always vega negative -- because the strikes closer to the money, that one sells, grow faster with a volatility increase than the strikes that one buys (further from the money)?

Edited by Rado

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