Options Theory: Gamma Scalping Part 2 – This is How you Scalp Gamma
December 20, 2019
Last update: July 2021
Gamma Scalping Series
Last week’s introduction laid out the theory of gamma scalping. This week we’re looking at a practical example. Buckle up – it’s going to be fun.
My previous message ended with this explanation:
“So how do you gamma scalp? You buy and sell shares of stock incrementally throughout the trade to keep the delta close to neutral. The benefit is you keep your directional exposure minimal so theta and vega can maintain their control as the primary drivers of the trade.”
This is best illustrated with an example.
Scalping Strangles
On Oct 22nd, IWM was trading for $154.50, and we sold a Dec $142/$163 strangle for $1.96. That means we shorted a $142 put and $163 call. I needed a big enough position to make it interesting, so we used two contracts. Here are the relevant trade metrics:
- Potential Profit: $196 x 2 = $392
- Delta: 0
- Theta: +3
- Gamma -10
The best-case scenario was for IWM to tread water, causing the strangle to decay in value toward zero. However, because of the negative gamma, our delta grows as the stock moved up or down, bringing directional exposure into what I wanted only to be a theta equation.
To keep the delta near zero (and thus our directional exposure minimal), we decided to hedge each time the stock moved up/down 1.5 to 2 ATRs. By using the risk graph, we were able to identify that the delta would grow from 0 to 30 or 0 to -30 if such a move took place.
Adjustment #1:
The trade was fine for the first few days, but on 10/29, IWM rallied to $157.12, or almost $3 higher than when we entered. The net delta of the position shifted from 0 to -30. To hedge, we bought 30 shares of stock.
Updated position:
- Short Dec $142/$163 strangle @ $1.96, Delta -30
- Long 30 shares @ $157.12, Delta +30
- Net Delta: 0
- Theta: +4
- Gamma: -10
Adjustment #2:
Fast forward to 11/5. IWM had rallied another $3 to $160, pushing the delta from 0 back down to -30 again. Time for another hedge. We bought 30 shares of stock to kick the delta back to neutral.
Updated position:
- 10/22: Short Dec $142/$163 strangle @ $1.96, Delta -60
- 10/29: Long 30 shares @ $157.12, Delta +30
- 11/5: Long 30 shares @ $160, Delta +30
- Net Delta: 0
- Theta: +4
- Gamma: -10
Exit & Final Tally
Fast forward to 12/5. The December strangle is now quickly approaching expiration. Gamma risk is rising, which will increase the difficulty of keeping the delta close to zero. As expiration nears, delta becomes unstable, like a mechanical rodeo bull that’s been turned up to ten. Against that backdrop, gamma scalping gets harder.
So, we decided to exit our entire position to take profits. The remaining reward wasn’t worth the elevated risk. This is a hard rule for me. Exit short strangles when expiration is within seven to ten days.
Final Tally:
- 10/22: Short Dec $142/$163 strangle @ $1.96, Delta -60
- 10/29: Long 30 shares @ $157.12, Delta +30
- 11/5: Long 30 shares @ $160, Delta +30
- 12/5: Close Dec $142/$163 strangle @ $1.57, Gain: $39 x 2 = $78
- 12/5: Close the 60 shares @ $162.77, Gain: $253
- Total Gain: $331
Notice how the bulk of my gain came from the added shares of stock. Had we not dynamically hedged the position, we only would have captured a $78 profit.
The incremental purchasing of shares kept my directional exposure at a minimum throughout the trade and allowed us to capture the lion’s share of premium available in the position. By selling two strangles for $1.96, we were shooting for up to $392 in profit. Departing with $331 is a win by any measure.
In our final installment of this series, we’ll address the tricky question of timing your hedges. Stay tuned.
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Wow, that’s good stuff. Zero commissions on stocks really open up hedging strategies that were not practical before.
Very compelling subject Tyler, thanks for sharing it. I have a some questions:
– How would the -10 gamma have affected the trade if IWM had moved down instead of moving up?
– Can hedging every 1.5-2 ATRs be used as a standard approach when trading this strategy with other indexes or stocks?
– What if after the first adjustment (+30 stocks), IWM had gone down a couple of ATRs, so price would come back to the inception price? What would be the delta in that scenario? What about the loss related with the +30 stocks from the first adjustment? Thanks
Great questions, David. Here are my responses.
1. If IWM had traded lower then we would have needed to short 30 shares to hedge each time the moved to +30 or so.
2. The 1.5 to 2 ATRs would probably work with other indexes/stocks, yes. In the third part of this series, I’ll discuss the timing of when to hedge in greater detail.
3. If IWM had gone back down the delta would have moved from 0 to -30, so I would have sold the 30 share hedge at a loss. The hope is that I made enough money in time decay to offset it.
Merry Christmas!