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

  • Premium at Risk

    Should options traders consider “premium at risk” when entering strategies? Most traders focus on calculated maximum profit or loss and breakeven price levels. But inefficiencies in option behavior, especially when close to expiration, make these basic calculations limited in value, and at times misleading.

    By Michael C. Thomsett,

    • 0 comments
    • 128 views
  • Diversified Leveraged Anchor Performance

    In our continued efforts to improve the Anchor strategy, in April of this year we began tracking a Diversified Leveraged Anchor strategy, under the theory that, over time, a diversified portfolio performs better than an undiversified portfolio in numerous metrics.  Not only does overall performance tend to increase, but volatility and drawdowns tend to decrease:

    By cwelsh,

    • 1 comment
    • 298 views
  • The Best Chart I’ve Seen in 2020

    The best visual aids for learning are often very simple. The chart in this article was created by Paul Merriman, using data from Dimensional Fund Advisors. I primarily use Dimensional Funds in building portfolios for my clients. There are many takeaways from this chart, and I’d like to share a few thoughts that stick out most to me.

    By Jesse,

    • 0 comments
    • 282 views
  • Traditional or Roth Retirement Account?

    When US investors save for retirement, there are many important decisions that have to be made including which investments to use as well as which type of accounts to fund. Tax favored retirement accounts such as 401(k)’s and IRA’s should be utilized to the maximum extent possible because of the opportunity for tax advantaged growth.

    By Jesse,

    • 0 comments
    • 309 views
  • My Favorite Investing Books, Blogs, Papers, and Podcasts

    There are so many excellent sources of investment education available today that I thought a short post about some of my personal favorites could be beneficial. Below are different forms of content that have been particularly impactful to my investment philosophy, and they are not in any specific order.

    By Jesse,

    • 0 comments
    • 644 views
  • Go For Gold! The Business Behind The Dazzle

    The price of gold is often in the news—sometimes it's rising, and other times it's dropping but for the most part, it has been on a steady increase for many years. It is certainly worth more now than it did twenty years ago. When its price is on the rise, we may have thought about the benefits of selling our gold for profit and making some passive income from it.

    By Kim,

    • 0 comments
    • 353 views
  • Using Bullish Calendar Spreads to Profit on MSFT Stock

    A calendar spread is an income trade where the trader sells a near term option and buys a longer-dated option with the same strike price. Usually this is done with monthly options, but it can also be done with weeklies. They are long volatility trades so can be a nice addition to a portfolio as a way to offset some short vega.

    By GavinMcMaster,

    • 0 comments
    • 679 views
  • 3 Principles to a Successful Investment Experience

    Although not an exhaustive list, what I’ll present in this article are three core principles that overwhelmingly stack the odds of a successful long-term investment experience in your favor. These three principles are asset allocation, diversification, and rebalancing.

    By Jesse,

    • 0 comments
    • 463 views
  • Important Tips For First Time Currency Traders

    Diversifying your portfolio is important for all investors, and currency investments are a great way to do that. However, there are a lot of misconceptions and common mistakes that first time currency investors make, and this leads to big losses.

    By Kim,

    • 0 comments
    • 490 views
  • Iron Condors or Short Strangles?

    In my early option trading days, I favored selling iron condors over selling strangles. I thought that selling a strangle was too risky because the potential loss was “undefined”. I thought this made sense because this is what I’d hear from other people that were more experienced than I was.

    By Jesse,

    • 0 comments
    • 2,051 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