TRADING TECHNIQUES

Stuck in a trading rut? Scalping option gammas is an active option position

management technique that extracts profits in midstream where you might
have thought there weren’t any.

Scalping option
gammas
BY DEAN MOUSCHER

um) position allows you to make delta of about -0.5, so your position

C
onsider this market scenario:
Treasury bond futures are in a money buying and selling the underly- is delta neutral. Each call and each
period of low volatility, with ing, with no risk of it ever moving put has a gamma of 0.17, so the entire
a daily range of half a point against you. To the contrary, every position has a total gamma of 17
or less. The options on these futures move of the underlying makes you (100 options times 0.17 gammas
are trading at historically low implied money. Using it in our scenario, you per option). We’ll see what that
volatility. With the futures at exactly could have made a small fortune. means in a moment.
112, you decide to buy a 50-lot in 112 To see how it works, let’s return to The day after you buy these options,
straddles (50 calls and 50 puts at the our initial scenario. These are our T-bond futures go up one point, to
112 strike). There are 45 days remain- assumptions: a risk-free interest rate of 113. Assuming that implied volatility
ing until expiration. 4%, an implied volatility of 6% and, remains unchanged, your software
The next day, the markets go wild. as we said, 45 days remaining until now shows each call is worth $1,516,
The daily range expands by two to expiration. T-bond futures are at and each put is worth $531, for a total
three points for the next few months. exactly 112. Each 112 call and each position value of $102,350. This
Nevertheless, at expiration the futures 112 put are offered at $937.50, equates to a gross profit of $8,600.
are again at 112 — exactly where they for a total price of $93,750.00 for Now things really get interesting.
were 45 days earlier when you bought the 50 straddles. You are no longer delta neutral. Your
the straddles, and exactly at-the- Using your options analysis soft- software shows that each call now has
money. Your straddles expire worthless. ware, you look up the delta and a delta of 0.67 and each put a delta of
The question is, did you make gamma values for these options. Delta -0.33, so your total position delta is
money or lose money? is the percent an option’s value now roughly 17.
If you said, “of course I lost money, changes as the underlying moves. That happened because whenever
my straddles expired worthless,” then Gamma reflects how much the delta you buy an option (put or call) the
it’s time you learned how to scalp of the option changes when the price most important thing you’re buying is
your gammas. of the underlying changes by one the wonderful property (unique to
point. The larger the gamma, the options) that as the underlying con-
SOMETHING FROM NOTHING more the delta can change for even a tract or stock moves, the delta of your
Scalping gammas is a professional small move in the underlying. In the option changes in the direction that is
position-management technique in case of our example position, each call favorable to you. As the underlying
which your long options (long premi- has a delta of about 0.5 and each put a moves up, the delta of calls becomes

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increasingly more positive, and the
delta of puts becomes less negative. POSITION MANAGEMENT
As the underlying moves down, the Every time the underlying makes a significant move, by making a futures transaction, you
delta of puts becomes increasingly return to delta neutrality.
more negative, and the delta of calls 115
becomes less positive.
When the straddles were bought, 114
the calls had a delta of 0.5 and the
puts a delta of -0.5. The puts and the 113
calls each had a gamma of 0.17. After
the one-point move from 112 to 113, 112
each call now has a delta of 0.67. Sell 13
That is equal to 0.5 + 0.17, just as the 111 futures
gamma predicted. Each put now has a Sell short 17 Sell 17 Buy 13
delta of -0.33, which is -0.5 + 0.17, 110 futures futures futures
again just as the gamma foresaw. The T-bonds at 112. Buy 17 Buy 17 Sell 17
total position gamma was 17 and, sure Establish the futures futures futures
109
enough, the total position delta went position of 50 Buy 17
straddles at 112. futures
from 0 to positive 17. 108
Of course, had the futures gone from
112 down to 111, to get the new delta 107
of each option you’d have to subtract 1 2 3 4 5 6 7 8 9
0.17. The total position delta would
now be about -17. And, just as when
the futures went up a point, you would you do, you’ve locked in your profit. If were sold short at 113, but you still
have a profit of approximately $8,600 the futures go back down to 112, made an overall profit of $6,400
(slightly less actually, see “The asym- you’re back where you started as far as ($23,400 minus $17,000) on the trip
metry of options,” in “Option trading the options are concerned, but you from 113 to 114.
facts,” page 40). have a $17,000 profit on your futures The option analysis software now
sale. You made $8,600 on the way up, shows a total delta on the options
ACTION TIME and about the same on the way down. of 30. Subtract the 17 futures you sold
Now, this scenario has us long 50 This is where you might wonder short, and you have a total position
straddles at a strike of 112, which what happens if the futures keep going delta of 13. You can lock in your
were bought when the futures were at up. You are short 17 contracts. profit again with a futures transaction
112. The futures have now risen one No problem. You’re long volatility. that brings you back to delta neutral.
point to 113. The total position delta With a long volatility position, any In this case, you sell short 13 more
has increased from 0 to 17, and the movement of the underlying (up or futures contracts.
position has a profit of $8,600. That’s down) is your best friend. If the futures continue going higher,
not bad for a day’s work. If the futures go a point higher to you’ll continue to make more money
But any reasonable trader might be 114, each call should now reflect a on your options than you’ll lose on
a bit nervous. After all, if the futures value of $2,250, and each put is worth your short futures, although the rate
go back down to 112, that profit $265, for a total value on your options of profit will keep declining the
evaporates, right? of $125,750. This is an increase of further away the futures get from the
Not necessarily. You can lock in $23,400 over the options’ value when original strike price.
your profit by selling short 17 futures the futures were at 113. You have a That scenario examined what
contracts. This brings you back to loss of $17,000 on the futures that would happen if the underlying con-
delta neutral. And that’s what
scalping gammas is all about.
Think of it this way: With the Follow your plan, or you’ll keep doing today
futures at 113, you are long 17 deltas,
the equivalent of being long 17 what you regret not having done yesterday,
futures contracts. So you have the
“right” to sell 17 futures contracts to
become delta neutral again. When
and you’ll drive yourself crazy.
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 Trading Techniques continued

tract rose. Consider what would hap-

Option trading facts pen if, instead of rising, the underly-
ing contract went down. If the futures
BY DEAN MOUSCHER fell from 112 to 111 right after the ini-
tial purchase, the 112 calls would be
worth $516 and the 112 puts would be
THE RIGHT INTEREST RATE worth $1,516, for a total position
One of the most frequent questions that comes up in options seminars is: value of $101,600 and a profit of
What is the correct interest rate to use when calculating theoretical option $7,850, a bit less than you made on
prices and implied volatilities? The answer: Your interest rate. the way up. The delta of the 112 call
If you bought options with money you would otherwise have put in three- would now be 0.33 and the delta of
month Treasury bills, then use the three-month T-bill rate. If you sold options the 112 put would be -0.67, for a total
short and your broker is paying you 2% on the resulting credit balance, use position delta of -17.
2%. If you bought options with money you would have used to pay down your As before, you can lock in your
7% mortgage, use 7%. profit with a futures transaction, this
And if you bought those options with money you borrowed from Louie the time by buying 17 contracts. If the
Loan Shark at 240% interest (not recommended, by the way), then 240% is the futures go right back up to 112, you’re
correct number to use. back where you started as far as the
straddles are concerned, but you’re up
$17,000 on the futures trade. If, after
THE ASYMMETRY OF OPTIONS you bought those 17 futures contracts
It would seem logical that if the futures are at 112, a 113 call would be worth at 111, the futures continued down to
the same as a 111 put. After all, they’re both one point out-of-the-money. But 110, your 112 calls would be worth
in reality, the 113 call is worth more. That’s because your option pricing model $250 each and your 112 puts would be
takes into account the fact that the downside is limited — the underlying can worth $2,250 each, for a total position
only go down to zero — while the upside is theoretically infinite. value of $125,000. That’s a further
To understand, think of silver when it was trading at $5 an ounce. Which increase in options value from
would you rather own, a $1 put, or a $9 call? Intuitively, you probably $101,600 to $125,000, or $23,400.
answered a $9 call, and you’d be right. Subtract the $17,000 you lost on the
Statistically, it is “harder” for the price to go from $5 down to $1 than from 17 futures contracts you bought at
$5 up to $9. A move from $5 to $4 is a 20% move. To get from $4 to $3 111, and you still pocketed $6,400 on
requires a 25% move, from $3 to $2, a 33% move, and from $2 to $1, a 50% the decline from 111 to 110.
move. Going from $5 to $6 also requires a 20% move, but from $6 to $7 only All of which brings up the three
requires a 17% move, from $7 to $8, a 14% move, and from $8 to $9 just a axioms of gamma scalping. When you
12.5% move.
start out with a position that is delta
That’s the basis of the asymmetrical “lognormal distribution” used in most neutral and long gamma: every time
option pricing models. It’s also the reason that if the underlying is at 112, the the underlying moves, up or down,
delta of a 112 call will be slightly above 0.5, and the delta of a 112 put will be you make a profit; every time the
slightly below 0.5.
underlying moves up, your position’s
delta increases, and every time the
underlying moves down, your posi-
SHORTING VOLATILITY tion’s delta decreases; and every time
When you’re short premium (short volatility) — say that you sold short 50, 112
straddles with the underlying at 112 — then with every move in the underlying
you buy or sell the underlying to
you lose money, your deltas move against you, and every time you buy or sell become delta neutral again, you’re
the underlying to return to delta neutral you’re locking in a loss. This is exactly locking in a profit.
the opposite of being long volatility. To further understand, consider this
The short-premium game is to keep your cool, and hope that each move of
executive summary of a gamma-scalp-
the underlying away from the strike price is temporary. If you can take the ing scenario (also see, “Position man-
pain and refrain from evening up your deltas, and if the underlying does agement,” page 39). With the T-bond
expire near your strike price, you will be handsomely rewarded. But if the futures at 112, you start out long 50,
underlying makes a big move…ouch! 112 straddles and delta neutral.
Premium sellers make money more often than not because most of the T-bonds go up to 113; you sell short
time, nothing much happens in the markets. But when the markets get roiled 17 futures. They go back down to 112,
and things move, losses can be huge. you buy 17 futures. They go up to 113,

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you sell 17 futures. They go up to 114, ple — and just stick with it. Follow
you sell 13 more futures. They go back your plan, or you’ll keep doing today
down to 113, you buy 13 futures. They what you regret not having done yes-
go down to 112, you buy 17 futures. terday, and you’ll drive yourself crazy.
They go down to 111, you buy 17 To the professional options trader,
more futures. They go back up to 112, options are a way to play volatility
you sell 17 futures. rather than the direction of the underly-
It might sound busy (it is), but each ing. Whenever you are long volatility
time you bought or sold futures in the (long options, long premium, long
above scenario, you returned to delta gammas) it’s a race of volatility against
neutral and locked in a profit. That’s time — the money you can make
scalping gammas, using your long- scalping gammas vs. the money you lose
gamma option position to make from time decay.
money buying and selling futures, by If you buy fairly priced options, you’ll
eliminating the risk of the underlying make about the same money scalping
moving against you. Once you return gammas as you’ll lose from time decay.
to delta-neutral, you make money if If you buy overpriced options — options
the underlying goes up or down. that have implied volatility higher than
the underlying’s actual volatility would
THE DOWNSIDE justify — you will lose more in time
This strategy isn’t meant to imply that decay every day than you can make
buying straddles can be made risk-free. scalping gammas. In that situation,
Whenever you’re long premium (long you’d be better off selling volatility
volatility), you lose money if implied short (if you have the nerves for it,
volatility falls. You also lose money if see “Shorting volatility,” in “Option
real volatility drops and you can’t scalp trading facts,” left).
gammas enough to offset time decay. But if you can find options that are
So while any movement of the underpriced — that is, trading at an
underlying is good, lack of movement implied volatility significantly below
hurts you. Again, that’s what it means the true volatility — then scalping
to be long volatility. gammas will allow you to profit from
The hardest part of this strategy is the discrepancy. It also will let you
knowing when to even up your deltas. profit from correctly guessing that true
If you water your lawn, you can be volatility will increase, as in our
sure it will rain and, by the same example. It doesn’t even matter if the
token, if you sell those 17 futures implied volatility never rises along
contracts at 113, it’s a sure thing that with the actual volatility.
the futures will continue up to 114. Scalping gammas also will allow
If you’re like most people, you’ll kick you to offset time decay if you’ve
yourself for having sold those futures bought option premium hoping for
too soon. You’ll vow not to make the a big move, while waiting for the
same mistake twice, and to refrain move to come. FM
from selling any more futures
contracts until they get up to, say,
Dean Mouscher was a long-time member of
115. Of course, the futures will then the Chicago Board of Trade (CBOT) and
turn around and go back down to 113, Chicago Mercantile Exchange. He traded
and you’ll have not a penny to show options on the floor of both exchanges for
many years. He has taught many option
for that last beautiful one-point move courses at the CBOT and other exchanges
from 113 to 114 and back. and private firms in the United States and
It’s inevitable when scalping gammas abroad. E-mail him at [email protected].
that you’ll rarely catch the exact turn-
ing points. The best advice is to deter-
mine a fixed strategy — such as scalp-
ing every point up or down, for exam-