The Good Ship Gamma

Posted On July 1, 2016 11:43 am

To say the recent market volatility is inhuman would be to an obvious understatement. The whipsaw action prompted by the “Brexit” saw six consecutive days in which the S&P 500 moved 1.5% or more and the full round trip of 4.7% down and 5% back up stands as the 3rd largest weekly reversal in over 8 years.

For option traders this shouldn’t necessarily be viewed as a bad thing. In fact if positioned correctly, this action represents massive opportunity. Like a surfer seeing a storm and the swells mounting one could sense a few weeks ago things were getting gnarly (yes, I’m 51 so go ahead and make fun) in this market. Likewise, a game plan is need. So before we head off to grill and chill over the July 4th weekend let’s review some trading tips and concepts for handling a high implied volatility environment.

As with most endeavors, Safety comes first, always, then maneuverability, that means scaling down positions size and only trading in liquid contracts and believe it or not leverage, being positioned to benefit from the powerful thrusts of strong directional moves.

The first two are easily addressable, 1) simple reduce your usual position size by a 1/3 or half, 2) with correlation, or the tendency for most stocks to move in unison focus on trading index funds such as Spyder Trust (SPY). Rather than trying to pick an exact entry point on an individual dinghy of a name use the battleship of ETFs to navigate swells. It may not be as exciting but it will most likely be less heart wrenching.

The tougher nut is how to get leverage on your side without adding exposure. Options are leveraged products (stemming from low margin requirement to control 100x number of shares per contract) but this leverage can cut both ways, big profits but also bone crushing losses. One of the keys to having the “right” kind of leverage having the right (in this case positive) gamma on.

Gamma is a second derivative and measures of how much your delta will change per unit change in price.   It means that as prices rise your delta increases. Or more pertinently as prices decline your delta turns more negative, meaning you get longer as prices go up, and shorter as prices decline. Sometimes people confuse gamma with vega which is a measure of volatility. They sometimes act in concert but are not related. Kinda like country and western. I have no idea what that means.

Here is a pretty graph of the gamma curve.

Gamma graph image 6.30.16

Notice how an options delta becomes more sensitive as expiration approaches. Essentially, on expiration day an ATM option acts just like owning or shorting the underlying shares.

Getting long gamma usually comes in the form of owning or being net long more options contracts then one is short. This can be for both puts and calls, individual positions or a broader portfolio. As a generic example the Optionsmith portfolio had a pretty positive delta three weeks ago (maybe approaching 25 one of the highest on record) as I was long a half a dozen or so individual names ranging from Morgan Stanley (MS) Toll Brothers and FireEye (FEYE).

I was getting a daily whacking. But thanks to using the SPY to set up bearish put positions, mostly back spreads in which you sell or short x number of puts and then buy or go long 3x-5x number of put contracts I had essentially created a portfolio that resembled a married put with the kicker of being long gamma on the downside. What does all that mean? The losses in the individual names, which mostly occurred last week, had been mostly offset by gains in the SPY gamma boy protection program.

Admittedly the ferocity of the snap-back rally caught me a bit flat footed and my May gains in the SPY puts have all but evaporated. But some of my longs have recouped a good portion of their losses and a few “leftover” calls that I thought would be worthless have perked up. On the whole, even though I didn’t manage the quick decline and rally, the overall construction of the portfolio held up well.

Being long gamma also provides flexibility. If you are short gamma (net short options and hence volatility) one usually has to take a defensive stance one large moves occur. By contrast being long gamma allows you to react and respond.

When the market gets wild, make sure you have some positions that all long gamma and will benefit from when prices move further than you expected. They tend to do that now and then.

About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.