Gamma Scalping in Action: Practical Examples and Pro Tips

Gamma scalping is a sophisticated trading strategy for options. Institutions and hedge funds use it extensively to manage portfolio risk and significant stakes in stocks and futures. Historically, gamma scalping was a commission-intensive approach due to the frequent trading. However, with the recent evolution of retail trading and the industry-wide reduction of commissions, this method is now more accessible to retail traders.

In short, gamma scalping entails entering and leaving a position through the underlying market in order to make adequate modifications to the delta of a long option premium to balance the time decay component of the option position as part of a long gamma portfolio.

This article will begin by defining gamma and delta before delving into how gamma scalping operates. Notwithstanding, investors should keep in mind that this method can be highly complex and requires a thorough understanding of options trading to implement.

Understanding the fundamentals

Let's first revisit the definition of gamma and delta, which is essential to comprehend the concept.

Delta gauges the effect of changes in the option's price compared to the underlying instrument's price. Depending on the strike price at which the option was purchased, the delta values can range from 0 to 1 for call positions and from 0 to -1 for put positions.

On the other hand, gamma quantifies the rate of change in an option's delta for a $1 change in the underlying stock price.

Positive Gamma

The gamma of an options position is positive when calls or puts are purchased. If the stock price rises, the call options' positive gamma will get more positive and reach +1.0. The delta of call options will approach zero if the stock price falls. On the opposite side of gamma, the opposite is true.

Negative Gamma

When options are sold, the gamma value is always negative. A short call option with a negative gamma will have an increasingly negative delta as the stock price increases. If the stock price declines, the delta value of the short gamma option position will increase.

The relationship between gamma and its expiration period is another crucial aspect of its comprehension – Gamma grows as the expiration date approaches for near-the-money options contracts. This occurs because the option's time value declines and begins to lose its extrinsic value while retaining its intrinsic worth.

Lastly, prior to engaging in gamma scalping, investors must comprehend the relationship between gamma and implied volatility. Understanding this link will assist in identifying the best points to hedge the exposure when scalping gamma.

Gamma will generally be more stable for all option strike prices when volatility is high: In such circumstances, the time value component of deep in-the-money and out-of-the-money options is already extremely high. Therefore, when the time value of options increases as they approach the money, gamma becomes less sensitive and more stable.

However, when volatility is low, gamma is more sensitive to striking prices. Gamma approaches 0 for deep in-the-money and out-of-the-money options. This is due to the fact that when volatility is low, the time value component of the options is low but will rapidly increase as the stock price approaches the strike price.

As can be seen, the relationship between gamma and delta is fundamentally tied to the option premium. Each time the delta of an option changes, so does the gamma. This relationship must be understood in order for investors to comprehend the variations in gamma as the stock price fluctuates.

Gamma Scalping, a complex but efficient trading method

Now we get down to brass tacks. Gamma scalping entails buying and selling shares of the underlying stock to offset the effects of daily decreasing theta, which is the cost of maintaining a long options position. Theta is always displayed as a negative number in an option chain and represents the amount by which the value of an option depreciates daily. Theta works against investors when they purchase an option and, in their favor when they sell one.

The gamma scalping approach begins with a long straddle and adjusts when the stock price rises or falls.

The initial setup consists of a long straddle with the same strike price. The transaction should be delta-neutral, and investors are advised to exit at least 45 days prior to expiration, with 90 days being the optimal expiration period. The initial trade setup will involve a predetermined level of risk.

If the stock price declines, investors will purchase x number of shares of the underlying stock based on the price change. If the price of the stock rises, they will sell shares short. Depending on the volatility of the stock they are trading, it is recommended that they begin purchasing or selling the underlying asset when their options have a minimum intrinsic value of $1.

This is merely a suggested minimum; they can increase it much further. They can use the underlying stock to lock-in that value when the option contract has a minimum intrinsic value of at least $1.

Gamma Scalping Strategies in Action – Basic Strategies and Examples

Now that we have a grasp on the fundamentals of gamma scalping, let's dive into why traders who hold long options should strongly consider trading their gamma. In options trading, time decay is measured as theta, which works in contrast to gamma. These two factors are polar opposites. So, when time decay erodes the value of our options, traders scalp gamma to recoup that lost time. This lies at the core of gamma scalping – traders take advantage of stock movements by trading its gamma, effectively reclaiming lost time.

This guide aims to provide you with deeper insights and practical examples to strengthen your understanding. First, we'll begin with a basic example using a hypothetical stock called XYZ. Following that, a short discussion on margins and then we will walk you through a trade discussed in the Discord group of Masters in Trading Community.

Understanding Gamma Scalping Through a Practical Example

Gamma scalping is a sophisticated options trading strategy that allows traders to hedge against small price movements in the underlying asset. While the concept might sound complex, breaking it down with a practical example can make it more digestible.

Consider the following table, which illustrates a series of trades using the gamma scalping technique:

In this example, a trader starts by purchasing 10 call options of stock XYZ when it's priced at $6. As the stock price rises, the trader sells (or shorts) shares, locking in profits at each price level. When the stock price drops, the trader buys back the shares, further increasing their profit. The net result of these trades, after accounting for the initial cost of the options, is a profit of $2,650, while the risk of the options position was limited to the original price, $500.

The beauty of gamma scalping is that it allows traders to profit from small price movements in the stock, while also providing a hedge against adverse price changes. The strategy is particularly useful in volatile markets where stocks can experience frequent and minor price fluctuations.  Pro Tip: When searching for stocks to trade, it's beneficial to consider those with a high beta (systematic risk) and affordable implied volatility. These make excellent choices for long option trades, potentially offering numerous opportunities for profitable gamma scalping strategies.

It is important to acknowledge that although gamma scalping offers the potential for significant rewards, it also carries certain downsides. One such downside is the requirement for additional margin to hold short stock alongside a long options position. To mitigate margin costs, it is advisable for brokers to offset these holdings. However, it is recommended to verify this practice with your respective broker.

Brokers and Gamma Scalping:

• Professional and Institutional Context: In institutional settings, brokers often provide tools and platforms that allow for easy delta hedging and gamma scalping. They understand the needs of professional traders and market makers who employ these strategies. 
  
  
• Retail Traders: For retail traders, not all brokers might offer the same level of flexibility or tools for gamma scalping. However, many advanced trading platforms do provide the necessary tools for traders interested in these strategies.
   
• Margin Requirements: It's essential to note that shorting stock requires borrowing and can have associated margin requirements. Brokers will often net out the exposure from long options against short stock positions, which can reduce the margin requirement. However, the specifics can vary from one broker to another.

Gamma Scalping Example: DBX Gamma Scalp Trade in Masters in Trading Community

Trade Background: On April 6th, a significant Unusual Options Activity (UOA) was spotted for DBX (Dropbox Inc.), a leading provider of cloud storage and content collaboration tools.

The activity showed a strong bearish sentiment:

• 5,600 Puts vs. 277 Calls traded on Wednesday.
• Cheddar Flow Scan highlighted Stocks, Sweeps, OTM.
• 4,600+ May 20 Puts were bought on Wednesday in two separate tranches.
• The stock price decreased at the time of these purchases.
• A total of $276,000 was spent on premiums.

Trade Execution: Based on this activity, we shared a REDLINE trade (typically shared on Fridays) within Masters in Trading Community:

• April 6th, 2023 Trade Recommendation: Consider buying May 21 Puts for $0.88 or May 20 Puts for $0.58.
• The massive UOA was the primary trigger for this trade recommendation.
• Following this, DBX's stock price dropped from $23 to $19, validating the bearish sentiment.

Gamma Scalping Opportunity: Stacy's Insightful Trade on 05.12.23

When stocks take a downturn, it often opens up prime opportunities for gamma scalping. Stacy Brovitz, CFA, a long time Masters in Trading member, recognized this and shared a strategic move with the Community. Post-earnings, as the stock dipped, Stacy made a timely decision to buy. Capitalizing on a subsequent significant bounce, he sold the stock, securing a profit of $2.00 per share. The icing on the cake? He's still holding onto his puts, which have now appreciated by a whopping 100%.

In Conclusion: Gamma Scalping: A Powerful Strategy

In conclusion, gamma scalping effectively counteracts theta decay in a long straddle position and provides a robust tool for hedging in volatile assets. It also serves as a means to safeguard against directional exposure.

However, it's important to note that gamma scalping can incur high trading costs and requires meticulous monitoring and a strong grasp of fundamentals for swift execution. A wrong hedging move can result in significant losses.

While complex, gamma scalping can succeed when market conditions and trade management align. Traders must closely track how stock price changes impact delta and gamma throughout the trade's duration to apply the strategy effectively.