Last update: July 2021

Gamma Scalping Series

1. Part 1: Intro to Gamma Scalping
2. Part 2: This is How you Scalp Gamma
3. Part 3: Timing Your Scalps

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In our third and final installment on Gamma Scalping, we’re addressing the challenging question of timing your scalps. If you missed parts one and two, go back and read them pronto. You’ll need the background for today’s comments to hit the mark.

First, let’s set the table. You’ve sold a strangle with the intent of profiting from time decay. Your position starts delta-neutral but carries enough negative gamma to get you long into weakness and short into strength. That means your delta grows negative as the market rises and positive as it falls.

At the beginning of the trade, you’ll need to decide how much you’re willing to let the delta grow before you hedge it back to neutral.

Picture yourself walking your dog on a busy city sidewalk. Sparky has a collar and a leash, which gives you ultimate control over how far he wanders. Before you left the house, you had to decide how long of a leash to use because you have two of them, one short and one long.

Each one boasts tradeoffs:

• Short: Pro- Sparky will always remain close, limiting the amount of trouble he can get in to. Con- You’ll have to frequently yank him back to you, requiring more monitoring and muscle use.
• Long: Pro- Since you’ll rarely have to yank Sparky back, the amount of monitoring and muscle use will be less. Con- Sparky will have plenty of rope to hang you and himself when he pees on a police officer.

Expected Move

My default metric for determining when to hedge is to start with the expected move. Here’s a simple way to view whether or not a short strangle will profit in formula form.

• Actual Move < Expected Move = Short Strangle Wins
• Actual Move > Expected Move = Short Strangle Loses

Let’s express it differently. If I sell a strangle and the market moves less than expected, then I should make a profit. If I sell a strangle and the market moves more than expected, then I should incur a loss.

Here’s one more way to think about it. Remember that we profit due to time decay (theta) while losing if the stock moves too far against us (delta).

• Theta Gains > Delta Losses = Short Strangle Wins
• Theta Gains < Delta Losses = Short Strangle Loses

You can find the expected move (hereafter referred to as “EM”) in the IV Rank indicator. By default, it will reveal the daily, weekly, and monthly EM. In case it wasn’t obvious, the EM is directly related to time. Thus the EM over one week is larger than that over one day.

Based on current implied volatility, options are pricing in daily moves of $1.60 for IWM. I can re-word the above statements to put it in the context of selling a strangle in IWM and determining if I will make a profit today.

• If IWM moves less than $1.60 today, then the short strangle will profit.
• If IWM moves more than $1.60 today, then the short strangle will lose.

This assumes that all else remains equal. If implied volatility shifts up or down it would add/subtract to my gains.

Timing the Hedge

The general answer for timing your hedge (or “scalp”) is to do it when the market moves more than expected. Today that translates into a rise/fall outside of $1.60. If IWM moves less than $1.60, then I wouldn’t hedge. I would never go tighter than that but would consider going wider if I wanted to use a looser leash.

With the IWM case study highlighted in Part 2, we used 1.5 to 2 ATRs as the rule of thumb for when to hedge. That ended up being around 1.5x the expected move.

On a side note, it makes sense that ATR and EM go hand in hand. If the ATR is low because the market is quiet (like now), then option prices will be cheap, and the EM will be small. If the ATR is high because the market is crazy volatile, then option prices will be expensive, and the EM will be large.

Once you’ve decided on the level of fluctuation you’ll allow before hedging, you can translate that dollar move into a certain number of deltas by either using gamma or modeling it on a risk graph. For example, if my gamma is -10 and the EM is $2, then I would see a delta move of 20 before needing to hedge. If my gamma was -30 and the EM is $3, then the delta could move by 90 before needing to hedge.

Summary

In closing, let’s summarize the key points of this three-part series.

1. First: free stock commissions increase the appeal strategies that involve frequent stock purchases like gamma scalping.
2. Second: short strangles are the simplest way to game time decay and start out delta neutral.
3. Third: because of gamma, strangles gain deltas as the stock price rises/falls.
4. Fourth: by dynamically hedging, we can keep the delta close to neutral.
5. Fifth: we can use the expected move to determine when to hedge.

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