Last Update: July 2021
I see you checkin’ out those short-term options, son. One-week derivatives have a magnetic pull stronger than Hercules. What with their sky-high theta and all. Who doesn’t like loosening Father Time’s restraints a bit so he can really work his profit-giving magic? There’s no doubt that covered call and naked put systems (not to mention credit spreads) that involve selling short-term options boast higher profit potential than, say, selling one or two month options.
Of course, the operative word in that sentence is “potential.” Which is not synonymous with “guarantee,” much to the chagrin of many who mistakenly think so.
Yes, indeed, when you run the numbers selling one-week options delivers bigger gains than selling one-month options. But those numbers, much like the offhand stats uttered by every politician, are misleading. They fail to illustrate the elevated risk associated with this approach fully.
‘Tis a devil we veterans like to call gamma risk.
Rather than take a deep dive down the treacherous greeks hole, let’s keep today’s explanation practical. Here are a few bullet points to lay the groundwork.
Gamma risk only exists when selling options. So if you’re buying calls or puts you needn’t worry about this particular bogeyman.
Gamma refers to how fast your directional exposure changes.
Since “directional exposure” and “delta” are synonyms, we can rewrite the previous sentence to Gamma measures how fast your delta changes.
The higher your gamma, the quicker your losses will rack up if the market moves adversely.
The lower your gamma, the slower your losses mount.
Short-term options have the highest gamma.
Picture delta as a mechanical bull. Gamma is how quickly the bull is bucking.
When you’re trading long-term options, the bull is stable. Like a gentle pony ride. Even large adverse moves in the underlying stock don’t have much impact on your overall position delta. You’ll still rack up losses, but they’ll be gradual.
When you’re trading short-term options, the bull will be bucking and jiving like his family jewels are in jeopardy. Your losses will climb quickly, egged on by gamma’s devilry.
One of my favorite ways to illustrate this is with a risk graph. Gamma is known as the curvature of an option. And in case you didn’t know, in the land of option graphs, more curve when selling options is no bueno since it translates into more significant losses. Interestingly, from a risk perspective – the flatter the graph the better.
The following graphic shows a short-term Iron Condor in blue and a long-term one in orange. Focus on the dotted lines which represent the trade’s behavior today. Since the blue one has more gamma risk its line drops into the loss zone much faster than the orange one.
Here’s the bottom line: if you want to sell really short-term options, fine. But don’t think you’re getting something for nothing here. The higher rate of time decay comes at a cost. And that cost is quicker losses if your wrong, or gamma risk, as the cool kids say.
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3 Replies to “Options Theory: Gamma Risk”
Completely agree with you Tyler, been bitten a couple of times by high gamma. I find it much easier to think and react with a lower and ideally a slower gamma. Thanks again!
Aloha Tyler. I have not posted before now. I just want to thank you for your informative posts. I enjoy reading and learning from your writings. Thanks and Happy New Year.
Thanks for chiming in Lawrence! I appreciate you following the blog and am happy to help you along the learning curve.
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