Definition

Gamma scalping is the process of adjusting the deltas of a long option premium and long gamma portfolio of options in an attempt to scalp enough money to offset the time decay of the position.

Practical Purpose

The trader is usually under the impression that the market is going to make a substantial move in one direction or the other with a long straddle or strangle. Hopefully, the move is large enough to offset the cost of the straddle and then some. A downside move can be an added benefit in terms of an explosion in implied volatility which will further help the position. The downside to this strategy is that you may have to wait a while for your anticipated move to come which will force the position to lose money daily because of time decay (theta). Offsetting the theta and buying patience is the purpose of the gamma scalping strategy.

Thinking

Suppose that you felt that the markets were going to make a substantial move, for whatever reason. Earnings, economic data, banks collapsing, elections, etc. are all valid reasons to think a large move is potentially going to happen.

In this example, we are under the impression that IBM is going to have horrendous earnings. Let’s say that we know the economy is in the dumps and we believe that most corporations are not going to be spending money on new technology since they are laying people off. For some reason, the analysts have shifted their earnings estimates down slightly, but are still optimistic about IBM. One could certainly argue that a surprise here would have to be to the downside, but maybe things are not as bad as we thought. In addition, suppose that the implied volatility levels on IBM are near their low end of the range. This is an ideal situation to trade a straddle.

Why we are worried about IBM?

  1. We believe the analysts are over optimistic.
  2. We know that the implied volatility levels are low.
  3. We believe business is slowing down because of a lack of spending on new technology.
  4. Earnings are out in 2 weeks.
The Trade

We decide to go out and buy 20 IBM straddles.

The stock is at 96.14, so we will buy the 95 call and put

The 95 call is at $3.20 (19 days until expiration).

The 95 put is at $2.20.

The straddle will cost us $5.40.

The Math

Delta X 20   Gamma X 20   Theta X 20
Buy 20 95 calls 58 1160 0.06 1.2 -0.07 -1.4
Buy 20 95 puts -42 -840 0.06 1.2 -0.07 -1.4
NET     320     2.4     -2.8

You see that the position starts out with a long delta of 320 because the calls, which have a positive delta, are ITM and have a 58 positive delta. We also see that the options have a gamma of 0.06. This may be a tad misleading at first since we have delta listed with the decimals removed, but gamma and theta still have their decimals. In addition, we see that this position loses $7 dollars a day per option (0.07 X 100 multiplier). Thus, the total position of 20 calls and 20 puts will have a daily time decay rate of $280. In other words, we will lose $280 in time decay every day that this position does not make money because of the movement of the stock. We want to compensate for this $280 with our gamma scalping.

Trades

Time Period #1

Once we put on our straddle, we will sell 300 shares of stock (or buy more puts/sell some calls) to get the delta close to zero. Since selling non 100 share increments of stock is not preferred, we will simply round off our delta to accommodate 100 share increments of stock.

Our starting position is:

  1. Long 20 calls for $3.20
  2. Long 20 puts for $2.20
  3. Short 300 shares of stock at 96.14

From here we do not care which way the stock moves, but we do want it to move.

Time Period #2

The stock can move in either direction, but to make this simple let’s say that the stock opens up at $2 the next day. The position is fine even being short 300 shares of stock. Also, keep in mind that the deltas are going to change so we will have to re-hedge.

Positions   1st $1 Move Gamma 2nd $1 Move End Price   PNL
Long 20 calls $3.30 $3.88 0.06 64 $4.52 $2,440.00
Long 20 puts $2.20 $1.78 0.06 -36 $1.30 -$1,800.00
Short 300 shares $96.14 -$300.00 -$300.00 -$600.00
NET             $40.00

You will notice that the stock went up $2, and even though we were short shares, we made $40 on the position. In addition, we will now have to re-hedge because our deltas have changed. The call delta is now 64 and the put delta is now -36. The net delta is now 28 positive deltas. A position that has 20 straddles equates to being long 560 deltas (28 x 20). Since we are short 300 shares, the real net delta now is short 260 (560 deltas – 300 shares). We have to sell 260 more shares, but let’s round up to 300 again.

Action

Sell another 300 shares (total short 600 shares).

Time Period #3

We have just sold our additional 300 shares, and we watch as the stock glides back down to the original starting price of $96.14, as stocks often do.

What will happen? Provided no variables have changed, the options will go back to their original starting price of $3.20 and $2.20. No profit or loss was made on the options. We did, however, sell 300 shares when the stock was up $2 on the day at $98.14. Now that the stock is back down in price and the deltas have changed back to the original starting position, we do not need the short shares.

In other words, when we started this trade, we were hedged with being short 300 shares when the stock was at $96.14. Now that the stock is back at $96.14, it would make sense that the original 300 share short position is all that is needed to be hedged. Yet, we are short 600 shares (300 at $96.14 and 300 at $98.14). We simply buy back the second set of short shares we sold at $96.14 and lock in a $600 profit (300 shares X $2).

Conclusion

Notice that the stock started and stopped at the same price as it often does when you are long straddles and want the market to move large. The daily time decay on this position is $280. Our scalping of 300 shares compensated for 2 days of time decay.

Start Price End Price   PNL
95 call $3.20 $3.20 $0.00
95 put $2.20 $2.20 $0.00
First 300 shares $96.14 $96.14 $0.00
Second 300 shares $98.14 $96.14 $600.00

Yes, the more the stock gyrates the more you can scalp and make. The danger is when the stock stagnates and doesn’t move in a large enough range to take money out of the changing of the deltas. In that case it is often wise to get out of the position quickly.

Gamma versus Theta

The most important consideration in gamma scalping is the relationship between gamma and theta.

Gamma

As time approaches expiration, the gamma level of an option increases. Like time premium levels, gamma also falls under the normal distribution curve with the at-the-money (ATM) options having the highest levels of gamma. This is why most people who gamma scalp elect to do so by using the ATM options to buy (or sell if reverse gamma scalping) straddles and strangles. A large portfolio of options at a wide variety of strikes with various spreads embedded in the position can still be gamma scalped as well.

The table below illustrates how gamma levels increase as time approaches expiration. Since gamma scalping is most effective with high levels of gamma to allow you to do more scalping, the front month options are the preferred tool to use when gamma scalping. Although, this does come with a cost. As we get closer to expiration, time decay hurts the position(s) more.

IBM GAMMA
12 days 40 days 68 Days
80 0 0.01 0.01
85 0.01 0.02 0.02
90 0.04 0.03 0.02
95 0.06 0.03 0.02
100 0.05 0.03 0.02
105 0.02 0.02 0.01
110 0.01 0.01 0.01
Theta

Being long straddles and strangles can be very costly with theta considerations. With gamma scalping we want a large gamma number (which is usually during the front month options), but those same options have a much higher time decay number than back month options. See the table below to get a better feel for this. Also notice that the normal distribution curve works the same way with theta as gamma and time premiums. Thus, the best options for gamma scalping are also the worst ones if long during the current expiration month.

IBM THETA
12 days 40 days 68 Days
80 -0.04 -0.04 -0.03
85 -0.05 -0.04 -0.04
90 -0.07 -0.05 -0.04
95 -0.1 -0.06 -0.04
100 -0.07 -0.05 -0.04
105 -0.04 -0.04 -0.03
110 -0.02 -0.02 -0.02
Gamma versus Theta Conclusion

You will notice a tug of war between theta and gamma. As one variable gets better, the other gets worse and vice versa. They are inversely proportional. There is a possible solution here which is explained next, but that depends on your opinion of the markets.

Large Move Up versus Large Move Down
Large Move Up

If you are gamma scalping because you think the market is going up you are MUCH better off staying in the front month. Recall vega. Vega is the measure of how much the option price will change with a 1 point change in volatility. Typically, if a market is increasing in price the implied volatility levels will decrease. Since vega decreases as time approaches expiration, staying in the front month will be more effective. You will lose less with a smaller the vega due to a decrease in the implied volatility levels.

  1. Stay in the front month.
  2. Keep an eye on theta. Make sure that you are scalping enough out of the positions to cover your time decay.
Large Move Down

Should the market swings become larger and/or the market sells off dramatically, an increase in implied volatility levels will typically result. In this situation you are better off going out an extra month or two. Why?

  1. The back month options have a larger vega. An increase in implied volatility will be more beneficial in the back month that has a larger vega.
  2. Theta will be lower. The back month options lose value slower due to time decay.
  3. The downside is that your gamma number will be smaller by going further out in time, but if you are correct in your opinion (about increased volatility levels), then the first two will more than make up for the lower gamma number.
Managing the Trade

We obviously could go into this trade in much more detail; however, that was done in the textOption Trading Guide to Understanding the Greeks.

In addition, many people often state when learning this strategy, “I can’t afford to buy or sell 600 shares of the stock.” This too is NOT a problem. Keep in mind that options have deltas just like stocks do. A share of a stock is 1 delta, whereas the delta of an ATM option is 0.50 deltas, or half of a share of stock.

If long too many deltas, you can trade an option that will get you short deltas. Simply buy puts if you want to add to the position, or sell some calls if you want to decrease the position size. The same works in reverse. If you are short deltas, you can sell puts to lower your position size, or you can buy calls to add to the position size.

For those who have not read the text, Option Trading Guide to Understanding the Greeks, but see promise in this strategy, we urge you to invest the time in reading it. Take a pencil and push it through some examples. Go to your broker’s paper trade site and play with these as if you really had the position on. We are confident that you will see the power in them.

Lastly, there are several ways (as outlined in the above textbook) to mange these trades, but the simplest way is often the best. Simply keep an eye on the money. When you can’t make enough scalping to outpace the time decay, it is often a good time to get out. Thank you very much.