How to Add Gamma Protection to Portofolio That Does Require Alot of Management
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By Kim
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:
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:
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:
RUT moved 50 points and our weekly trade is down 45%. Ouch..
The second trade performed much better:
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
Options Greeks: Theta, Gamma, Delta, Vega And Rho Options Vega Explained: Price Sensitivity To Volatility Options Theta Explained: Price Sensitivity To Time Options Delta Explained: Sensitivity To Price Options Gamma Explained: Delta Sensitivity To Price The Use And The Abuse Of The Weekly Options The Risks Of Weekly Credit Spreads Should You Trade Weekly Options? Make 10% Per Week With Weeklys?
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By Mark Wolfinger
Questions:
Do options ever become so expensive that it is no longer worthwhile to pay the high asking price to buy them? We may know that a news announcement is pending, but so do other investors —and they also want to buy options. Translation: Increased demand results in a significant increase in option prices and implied volatility. How can we determine whether a point has been reached such that we have a better opportunity to earn money by switching to negative-gamma (i.e., the opposite of our traditional) strategies?
For this discussion, let’s consider premium-buying strategies are limited to market neutral strategies like buying long straddles and strangles, buying single options, and trading reverse iron condors where you buy the call and put spreads, paying a cash debit to own the position
Similarly, the premium-selling strategies are limited to market neutral strategies like selling straddles, strangles and single options. Also the traditional iron condor (sell both the call and put spreads and collect a cash credit).
Answers:
It should be intuitively obvious that there has to be some price at which it no longer pays to buy options to own positive positive gamma. [For an extreme example, I hope that you would never pay $8 for a pre-earnings, ATM straddle on a non-volatile, $20 stock.] Thus, as intelligent traders, we are limited and cannot adopt our favorite strategies every time there is an earnings announcement pending. Due diligence is required, and that includes analyzing a substantial amount of historical data so that we can estimate what may happen in the future by looking at what occurred in the past. Such data includes:
Previous post-news price gaps. We want to know the largest and smallest (based on a percentage of the stock price) and the median gaps when this specific stock announced earnings results. We do not need results from the last 20 years because stock markets change over time and more recent history is far more important. I suggest using 3 to 4 years of data (12 to 16 news announcements). Why is this information so important?
The data provides a good estimate of how much you can afford to pay for the options. There are two ways to profit.
First, exit the trade whenever there is a satisfactory profit before news is released.
When implied volatility increases by enough, your position increases in value and it may be attractive to unload the position and lock in the gains prior to the news release.
When the stock makes a big move prior to the news release, the positive-gamma position will be worth far more than you paid for it —and that may be a profit worth taking.
Second, when we do wait for the news release, the profitability of the trade depends on the size of the price gap and the cost of the options.
By looking at past data, we have a reasonable estimate for the size of any future price gap and thus, the value of our option position. Obviously this is just an estimate and the current trade may perform much better or much worse than the average. But, it is that average that dictates just how much we should pay for our option position. If the ATM straddle is worth $6 (on average) immediately after the market opens after the announcement, then we should not be willing to pay as much as $6 to buy the straddle.
The average implied volatility must be considered. If the IV averages 34 for the time slot (i.e., number of days in advance of news), in which we buy the options then we cannot expect to earn a profit when paying 40.
The cost (IV) of buying the pre-news options at a variety of times. It is important to discover a good time to buy the options (i.e., before IV has risen too far in anticipation of the pending news).
The price history for the stock, in the days leading up to the news release: How often did the stock rally/fall enough to generate a good profit without bothering to hold until the earnings news is released? If this never happens for a given stock, then the price that we can pay for a the straddle decreases because one of our profit opportunities is not present.
Results. How would various gamma-buying strategies have performed in the past? This requires examining option-pricing data as well as the stock price.
There is a lot of data that a trader may analyze.
The work produces guidelines for making trades, and we depend on those guidelines to tell us when to enter, and when to avoid, using our methods.
The second question is more difficult to answer because so much depends on the individual trader. For example, some traders will never sell straddles or strangles because risk is too high. Others understand how to manage risk for such trades (most important is choosing proper position size) and would adopt the negative-gamma strategies when the option prices are so high that it is reasonable to anticipate earning a profit by selling them.
Be careful. If you decide that paying $9 for a straddle (or paying a 34 implied volatility) is too high to buy the options that does not suggest that it is okay to sell. Selling requires a decent edge. For example, if your maximum bid for a straddle is $6 (reminder: the average post-news straddle is worth $9), I would not want to consider selling that same straddle unless I could collect $12 (or an IV of at least 40). Those numbers describe my personal guidelines and you must choose your own.
There is a lot of work to do before investing your money into option trades. Fortunately SteadyOptions does the tedious analysis and we can trade their suggestions. There is no guarantee of success. However, it is always good to trade with the probabilities on your side — and that is what you get with your SO membership.
Related articles:
Options Trading Greeks: Gamma For Speed Why You Should Not Ignore Negative Gamma
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Mark Wolfinger has been in the options business since 1977, when he began his career as a floor trader at the Chicago Board Options Exchange (CBOE). Since leaving the Exchange, Mark has been giving trading seminars as well as providing individual mentoring via telephone, email and his premium Options For Rookies blog. Mark has published four options trading books. His Options For Rookies book is a classic primer and a must read for every options trader. Mark holds a BS from Brooklyn College and a PhD in chemistry from Northwestern University.
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By Kim
The Gamma is one of the most important Options Greeks.
It generally is at its peak value when the stock price is near the strike of the option and decreases as the option goes deeper into or out of the money. Options that are very deeply into or out of the money have gamma values close to 0.
Effect of volatility and time to expiration on gamma
Gamma is important because it shows us how fast our position delta will change as the market price of the underlying asset changes.
When volatility is low, the gamma of At-The-Money options is high while the gamma for deeply into or out-of-the-money options approaches 0. The reason is that when volatility is low, the time value of such options are low but it goes up dramatically as the underlying stock price approaches the strike price.
When volatility is high, gamma tends to be stable across all strike prices. This is due to the fact that when volatility is high, the time value of deeply in/out-of-the-money options are already quite substantial. Thus, the increase in the time value of these options as they go nearer the money will be less dramatic and hence the low and stable gamma.
As the time to expiration draws nearer, the gamma of At-The-Money options increases while the gamma of In-The-Money and Out-of-The-Money options decreases.
How to put gamma work for you
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. The closer we are to expiration, the higher is the gamma.
When you buy options and expect a significant and quick move, you should go with closer expiration. The options with closer expiration will gain more if the underlying moves. The tradeoff is that if the underlying doesn't move, the negative theta will start to kick off much faster.
When you sell options, you have negative gamma that will increase significantly as the options approach expiration. This is the biggest risk of selling weekly options.
Should you trade weekly options?
Selling options with closer expiration will give you higher positive theta per day but higher negative gamma. That means that a sharp move of the underlying will cause much higher 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.
Example
Lets sat you have a call with a delta of .60. If the price of the underlying security rises by $1, then the price of the call would therefore rise by $.60. If the gamma value was .10, then the delta would increase to .70. This means that another $1 rise in the price of the underlying security would result in the price of the option increasing by $.70, and the delta would also increase again in accordance with the gamma.
This highlights how moneyness affects the delta value of an options contract, because when the contract gets deeper into the money, each price movement of the underlying security has a bigger effect on the price. The gamma is also affected by moneyness, and it decreases as an in the money contract moves further into the money.
This means that as a contract gets deeper into the money, the delta continues to increase but at a slower rate. The gamma of an out of the money contract would also decrease as it moved further out of the money. Therefore, gamma is typically at its highest for options that are at the money, or very near the money.
List of gamma positive strategies
Long Call Long Put Long Straddle Long Strangle Vertical Debit Spread
List of gamma negative strategies
Short Call Short Put Short Straddle Short Strangle Vertical Credit Spread Covered Call Write Covered Put Write Iron Condor Butterfly Long Calendar Spread
Summary
Gamma measures the rate of change for delta with respect to the underlying asset's price. All long options have positive gamma and all short options have negative gamma. The gamma of a position tells us how much a $1.00 move in the underlying will change an option’s delta. We never hold our trades till expiration to avoid increased gamma risk.
Watch the video:
Related articles:
The Options Greeks: Is It Greek To You? Options Trading Greeks: Theta For Time Decay Options Trading Greeks: Delta For Direction Options Trading Greeks: Vega For Volatility Why You Should Not Ignore Negative Gamma Short Gamma Vs. Long Gamma
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By Kim
Introduction
In November of 2012, CBOE and C2 issued Information Circulars IC12-093 and IC12-015 announcing the expansion of the number of Weeklys that can be listed for certain securities. CBOE and C2 may now list up to five consecutive Weeklys in a class provided that an expiration does not coincide with one that already exists.
According to CBOE, "Weeklys were established to provide expiration opportunities every week, affording investors the ability to implement more targeted buying, selling and spreading strategies. Specifically, Weeklys may help investors to more efficiently take advantage of major market events, such as earnings, government reports and Fed announcements."
Not every stock or index has weekly options. For those that do, it basically means that every Friday is an expiration Friday. That opens tremendous new opportunities but also introduces new risks which can be much higher than "traditional" monthly options.
Basically, just about any strategy you do with the longer dated options, you can do with weekly options, except now you can do it four times each month.
Let's see for example how you could trade SPY using weekly or monthly options.
Are they cheap? Lets buy them
SPY is traded around $218 last Friday Aug. 19, 2016. Looking at ATM (At The Money) options, we can see that Sep. 16 (monthly) calls can be purchased at $2.20. That would require the stock to close above $220.20 by Sep. 16 just to break even. However, the weekly options (expiring on August 26, 2016) can be purchased at $1.08. This is 50% cheaper and requires much smaller move.
However, there is a catch. First, you give yourself much less time for your thesis to work out. Second and more importantly, the weekly options are much more exposed to the time decay (the negative theta).
The theta is a measurement of the option's time decay. The theta measures the rate at which options lose their value, specifically the time value, as the expiration draws nearer. Generally expressed as a negative number, the theta of an option reflects the amount by which the option's value will decrease every day. When you buy options, the theta is your enemy. When you sell them, the theta is your friend.
For the monthly 218 calls, the negative theta is -$4.00. That means that the calls will lose ~1.8% of their value every day all other factors equal. For the weekly calls, the negative theta is a whopping -$7.70 or 7.1% per day. And that number will accelerate as we get closer to the expiration day. You better be right, and you better be right quickly.
Buying is too risky? Maybe selling is better?
If this is the case you might say - why not to take the other side of the trade? Why not to use the accelerating theta and sell those options? Or maybe be less risky and sell a credit spread? A credit spread is when you sell an option and buy another option which is further from the underlying price to hedge the risk.
Many options "gurus" ride the wave of the weekly options trading and describe selling of weekly options as a cash machine. They say that "It brings money into my clients account weekly. Every Sunday my clients access their accounts and see + + +.” They advise selling weekly credit spreads and present it as a "a safe option strategy because we’re combining an option purchase with an option sale resulting with a credit into your account".
This short term option trading strategy can work very well... until it doesn't.
Imagine for example someone selling a 206/205 put credit spread on Thursday June 23, 2016 with SPY around $210.80. That seems like a pretty safe trade, isn't it? After all, we have just one day, what could possibly go wrong? The options will probably expire worthless and the clients will see more cash in their account by Sunday. Well, after the market close, news about Brexit took traders by surprise. The next day SPY opened below $204 and the credit spread has lost almost 100%. So much for the "safe strategy".
Of course this example of weekly options trading risks is a bit extreme, but you get the idea. Those are very aggressive trades that can go against you very quickly.
Be Aware of the Negative Gamma
So what is the biggest problem with selling the weekly options? The answer is the negative gamma.
Condor Evolution. Source: http://tylerstrading.blogspot.ca/2010/09/condor-evolution.html
The 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. When you buy options, the gamma is your friend. When you sell them, the gamma is your enemy.
When you are short weekly options (or any options which expire in a short period of time), you have a large negative gamma. Any sharp move in the underlying will cause significant losses, and there is nothing you can do about it.
Here are some mistakes that people make when trading Iron Condors and/or credit spreads:
Opening the trade too close to expiration. There is nothing wrong with trading weekly Iron Condors - as long as you understand the risks and handle those trades as semi-speculative trades with very small allocation. Holding the trade till expiration. The gamma risk is just too high. Allocating too much capital to Iron Condors. Trying to leg in to the trade by timing the market. It might work for some time, but if the market goes against you, the loss can be brutal and there is no another side of the condor to offset the loss.
The Bottom Line
So is the conclusion that you should not trade the weekly options? Not necessarily. Short term option trading can be a good addition to a diversified options portfolio - as long as you are aware of the risks and allocate only small portion of the account to those trades.
Just remember that those options are aggressive enough to create quick profits or quick losses, depending on how you use them.
Related articles:
The Options Greeks: Is It Greek To You? The Risks Of Weekly Credit Spreads Options Trading Greeks: Gamma For Speed Options Trading Greeks: Theta For Time Decay Why You Should Not Ignore Negative Gamma Make 10% Per Week With Weeklys?
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By GavinMcMaster
Unfortunately, most people are being misled when it comes to Iron Condors. The potential gains are certainly amazing, but the risks are high as well.
Anyone trying to achieve a 5% per month return is likely taking on a lot more risk than they realize.
I’ve heard this story from beginner traders too many times to remember – “everything was going great, I was making loads of money with my weekly condors, and then WHAM, I lost 6 months’ worth of gains in 1 week”.
Those are the risks when it comes to Iron Condors, and the shorter the timeframe you are trading, the more likely you are to suffer a catastrophic loss at some point.
Early February was a prime example. Anyone trading weekly Iron Condor would have been killed.
GAMMA RISK
Short-term Iron Condors have a huge amount of Gamma risk. Gamma risk is effectively price risk.
Trades with negative gamma will suffer from a big move in the underlying stock. Iron Condors as you might have guessed, are short gamma.
Short-term Iron Condors have a lot more negative gamma (or price risk) than longer term Iron Condors.
Let’s evaluate two theoretical examples set up just before the recent selloff.
SHORT-TERM IRON CONDOR
This short term Condor could have been set up towards the close on Thursday February 1st when RUT was trading at 1575.
LONG-TERM IRON CONDOR
This longer-term Condor could have also been set up late on Thursday the 1st of February. Notice that between the two examples, Delta and Vega and almost the same, but the longer-term trade has almost no Gamma.
The trade off is lower Theta as Gamma and Theta go hand in hand.
ONE WEEK LATER
Let’s fast forward to the close of trading on Monday February 12th and RUT has dropped nearly 100 points to 1496.
The short-term Condor has been well and truly crushed and is down over $10,0000.
In comparison, the long-term Iron Condor is actually in profit to the tune of $100!
SHORT-TERM CONDOR
LONG-TERM CONDOR
I hope you enjoyed this case study, if you want to learn more about how to manage Iron Condors, join me for a live training session coming up soon.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. He likes to focus on short volatility strategies. Gavin has written 5 books on options trading, 3 of which were bestsellers. He launched Options Trading IQ in 2010 to teach people how to trade options and eliminate all the Bullsh*t that’s out there. You can follow Gavin on Twitter.
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By Kim
The following video shows how the Theta impacts options pricing. It examines few live examples of different options strategies.
Download video and slides:
Options Greeks - The Theta.wmv
Options Greeks Theta.pptx
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