Long Gamma or Short Gamma?

At ONN.tv, you will frequently hear Jud Pyle and I talk about our unwavering favoritism to selling premium.  While both of us prefer to collect theta and be net sellers of premium in our current capacity, it truly depends on the product you are trading and the opinion you have on that stock’s direction and volatility.

For beginner investors, being short or long gamma may not have much significance in the beginning of their trading life.  Most retail traders are more concerned with the ultimate outlook they have for the underlying instrument they are trading.

In other words, most retail traders tend to use different options strategies based upon their risk/reward characteristics and bullish or bearishness.  This moderate amount of ignorance is okay, as long as it is successful and repeatable.  But as one progresses farther and farther into the options universe, understanding the second derivative, gamma, becomes more and more important as you monitor your trading.  Understanding gamma completely is not necessary to trade options, but it should be learned.

Gamma, which measures the rate of change of the delta, can play a large part of the change in behavior of your option trade or spread.  Gamma, like delta, can and will change as the option moves closer to expiration and as the underlying stock and volatility change.  Gamma specifically measures the rate of change in an option for every one-point move in the underlying stock.

When you purchase an option, whether it be a call or a put, you are getting long gamma, which means that delta is changing in the direction you would want it to. In other words, when you purchase a call with a delta of .60 and a gamma of .05 and the stock moves up a dollar, your new delta might be something like .65, which essentially you are getting ‘more bullish’ as the stock rises, which is a good thing.  If that same stock were to drop 1 dollar, the new delta might be something like .55, making your option position less bullish and thus having less relation to the stock’s movement.

In the professional market-making word, one of our objectives was to remain relatively delta neutral, which meant we had to buy or sell stock (or something else) against our trades to mitigate our exposure to the underlying stock’s movement.  So if we bought a call with a .50 delta, we might sell 50 shares of stock to delta neutralize our position.  IF that stock went even higher, I was forced to sell even more stock, because remember my call delta was increasing.  Then if the stock came back down (like they often do) I could buy back those shares I sold as a hedge to make a profit.  Hopefully I made more money ‘scalping my stock’ then I was paying in theta or time decay each day.

By the way, when you buy ANY option, you are typically paying theta, which means it cost you money each day to be in that position, but like I said earlier, you are long gamma and you want the stock to move up and down so you can scalp your hedges or so your call or put option will be worth more money because the stock moved favorably.  When I was young, most of my money was made on collecting edge (the difference between an option’s theoretical value and what you were able to buy or sell it for) as well as making bets on volatility.  I also considered myself a darn good scalper of stock. Very seldom did I want to take a large directional (delta) position in a stock, because stock movement was much harder to predict.

So back to gamma. When a trader is long gamma, he or she has the ability to scalp stock (for a profit) against his position to help offset what that options’ position is costing him.  Being long gamma is warranted in some situations, typically if a stock is expected to be very volatile.

Short gamma, on the other hand, means you want that stock to stay perfectly still if at all possible and also most short gamma positions want to see a decrease in implied volatility once the position is put on.  This is logical, because if buying options makes you long gamma, selling options makes you short gamma.  A position that is short gamma can really behave oddly if you are not used to it.

Short gamma means your position deltas are moving opposite to what the underlying stock is doing, so if you are short a call and the stock begins to move higher (not a good thing), you get shorter and shorter, which would mean you would have to buy stock to remain delta neutral. Then if the stock drops you get positive delta, which means you  may have to sell stock to neutralize.  Some of you are scratching your heads, thinking that situation makes NO sense; buy high, sell low, how do I make money?  Well, remember when you are short options you are COLLECTING theta; time is benefitting your position.  This is true for both calls and puts.  Hopefully when you are SHORT Gamma, those losses from your negative scalping will be less than the theta you are collecting

So as you begin to understand more and more about position behavior, think about what gamma situation you would like to find yourself in.  There is no right answer, because there is a time to buy and a time to sell options.  But I encourage you next time you make a trade, whether it be a single option or a spread, take a look at your Gamma and watch how it behaves as you progress towards expiration.  Also remember that gamma is greatest in the at-the-money options, which means you will see your biggest change in delta the closer the option is to the stock price.  Gamma is also greatest in those options right before expiration, because remember that an option will either have a delta of 1 or 0 at after expiring and the gamma will help dictate how fast it will change.

Hope your tryptophan high has allowed you soak up this data like a good gravy on stuffing; have a great weekend!