SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

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.

 

Related articles

 

Want to learn more about options?

 

Start Your Free Trial

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • The Big Loss

    At his blog, Joey offers his perspective on the top reason that so many trader wannabes are not, and will not, become profitable traders. His post is titled: Learn to Lose Money to Make Money. Here are the Excerpts from the blog.

    By Mark Wolfinger,

    • 0 comments
    • 260 views
  • ETF Vs. Stock: Note Down the Vital Points

    Today’s small investment can fulfill your dream of high living tomorrow. But investing blindly can make it reverse. We all want to get a high return on our investment. Stocks or ETFs can be the best option for you in such cases. The investment in stocks or ETFs is not very different except few noticeable points.

    By Kim,

    • 0 comments
    • 292 views
  • Considering Trading? Here Are Some Trading Options You Need To Know

    Whether you are considering dabbling in day trading or looking for a longer-term investment if you want to start trading it will serve you well to carry out a little due diligence in advance. There are a number of markets that you could use and understanding how each one works and what they are all about is key.

    By Kim,

    • 0 comments
    • 5,877 views
  • Why Should You Paper Trade Options

    In my previous article I shared some thoughts why I believe traders should start with paper trading before committing real capital. Not everyone would agree, but today I would like to share another article by a trader I respect very much. The original article was published here

    By Kim,

    • 0 comments
    • 295 views
  • Is Long Call Better than Bull Credit Put Spread?

    The trigger to this article was a question posted on the forum: "why we should use bull credit put spread when you can just long call they both have limited loss both in long call you have unlimited profit why limited it with bull put spread?" You can read the discussion here.

    By Kim,

    • 0 comments
    • 446 views
  • Strike Selection: A 'Sweet Spot' for Option Sellers?

    The words above are powerful because they're approach-agnostic. It doesn't matter if you're an old-school pit trader who swigs grit instead of coffee before the opening bell, or a Gen Y technocrat who codes trend-detection algorithms. All traders live and die by The Four Words. If you consistently buy low and sell high, then you will be profitable.

    By Kim,

    • 0 comments
    • 1,559 views
  • Post-Earnings Implied Volatility Crush

    Earnings crush is the fall in implied volatility after earnings is announced. Typically, earnings announcements cause the price of the stock to move more than normal. The move will have more effect on short dated expirations since the day of earnings large move has more weight than the rest of the days with normal moves. 

    By ORATS_Matt,

    • 0 comments
    • 352 views
  • Why Not to Hold Strangles Through Earnings

    In my previous article, I described a strategy of buying strangles a few days before earnings and selling them just before earnings. In this article, I will show why it might be not a good idea to keep those strangles through earnings.

    By Kim,

    • 0 comments
    • 387 views
  • How to Prepare for Crypto Downturns

    Most cryptocurrency owners skipped a heartbeat when the bitcoin fell to 50% from its all-time high. According to experts, such nasty downturns are natural, and the crypto market may witness such downturns now and then.

    By Kim,

    • 0 comments
    • 520 views
  • Tradier Brokerage Special Offer

    Tradier Brokerage is partnering with SteadyOptions to offer a special promotion for SteadyOptions customers: Open an account with Tradier Brokerage and get no subscription fees for 3 months, plus all ACAT fees will be waived. After opening an account, you will also receive 3 months of free access to TradeHawk, our full-featured customizable trading platform.

    By Kim,

    • 0 comments
    • 662 views

  Report Article

We want to hear from you!


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?

Share this comment


Link to comment
Share on other sites

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.

Share this comment


Link to comment
Share on other sites

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.

Share this comment


Link to comment
Share on other sites

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.

Share this comment


Link to comment
Share on other sites

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. 

Share this comment


Link to comment
Share on other sites

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. 

Share this comment


Link to comment
Share on other sites

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

Share this comment


Link to comment
Share on other sites


Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!


Register a new account

Sign in

Already have an account? Sign in here.


Sign In Now

Options Trading Blogs Expertido