Gamma Scalping: An Effective Method of Portfolio Hedging

Gamma Scalping: An Effective Method of Portfolio Hedging

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.

Figure 1: Gamma scalping, long straddle. Source: Nasdaq

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 is Effective

In conclusion, gamma scalping can effectively mitigate the consequences of theta decay on a long straddle position while also assisting investors in properly hedging and managing portfolio risk in volatile assets. In addition, it can be a suitable hedging method against directional exposure.

However, investors should remember that gamma scalping can soon become highly costly in terms of trading costs and that it requires careful monitoring and a solid grasp of the fundamentals to be deployed rapidly. Moreover, putting the incorrect hedging transaction can result in substantial losses.

Although gamma scalping is complex, it can be successful provided optimal market circumstances and trade management are satisfied. Traders must pay close attention to how changes in the stock price impact delta and gamma during the life of the trade in order to use the method correctly.

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