The Greeks: Trading with Negative Gamma

Options traders can enjoy positive theta (time decay); however, these positions come with negative gamma (rate of change in prices) which can translate to a significant potential loss. Some traders prefer to hold options, along with the possibility of achieving large profits occasionally. However, the downside of this position lies in negative theta, meaning that the position will consistently lose money unless the asset price moves enough to offset the time decay. Whether to take a long position or a short position is one of the main decisions for a novice options trader.

Background information for new readers on the concept of using Greeks to measure risk.

Negative gamma positions with positive theta (time decay) are a high-risk strategy that requires the proper position size and skillful risk management. If you choose to risk holding negative gamma positions, the best way to avoid risk is to hold positions with limited risk. Gamma is a second-order Greek because it measures the rate of change of another Greek (delta) with stock price, not how the option price itself changes. When trading negative gamma positions, use a risk chart to inform you when you are at risk of losing a significant amount of money or when the position exceeds your comfort zone.

Find your comfort zone

The best long-term solution for options traders is to discover your individual comfort zone. If you choose to risk holding negative gamma positions, the best way to avoid risk is to hold positions with limited risk. In other words, for every option sold, buy another option of the same type (put or call) at a lower cost. Suggestion: Trade credit spreads instead of selling naked options. If you decide to take a position with positive gamma, we can assume you own an out-of-the-money call option. Here’s an example:

Stock Price: $74

Strike Price: $80

Days to Expiration: 35

Volatility: 27

Theoretical Value: $0.61 (according to an options calculator)

If the stock price rises, you can expect to make money. However, due to negative theta, if too much time passes, the option may lose value even when the stock price rises.

Example

Consider some stock prices and watch them for one week. Pay attention to gamma and how it affects delta. Let’s take a look at the table below for reference.

Gamma increases as the stock price rises – until the option delta approaches 50. To understand why gamma does not continue to increase after a certain point, just think about the option delta if the stock price were $200. At this price, the delta would be 100, and the option would move point for point with the stock. Delta cannot be greater than 100, thus there must be a point where delta stops increasing.

Note: Theoretically, gamma remains positive but becomes less positive. If this is true, there must be a point where gamma declines and approaches zero.

As the stock price rises, delta increases, at least until it reaches 100. Therefore, for every dollar change in the stock price, delta is higher than it was previously, and the rate at which the option gains value accelerates.

When this option was purchased, delta was at 19 (the table shows delta at 16 because this data point is taken after one week). If the stock price rises to $76, there is an expected profit of about $38 (2 * 19). In the table, the profit was only $24. It would have been $47 if time had not passed.

With
The stock rose by an additional two points, and the value of the option increased by $0.62. This is much higher than the profit generated from the previous two-point increase. An additional two-point rise to $80 adds $92 in profits. Again, the rate of money-making accelerates.

As delta increases, the rate of making profits on call options also increases with the rising stock price. Thus, gamma plays a significant role in the profit/loss potential in options trading. Delta option 19 became delta option 52 when the stock price rose from $74 to $80 in one week. Thank you, gamma!

Second Degree Gamma

Gamma is a second-degree Greek because it measures the rate of change of the other Greek (delta) with stock prices, not how the option price itself changes. Do you remember when gamma changed from 4.4 to 6.5? Gamma not only increased delta and the profits of the option holder but also accelerated those profits as gamma itself grew.

In conclusion, positive gamma is beneficial for the option holder while the cost of having that gamma is theta. Positive gamma leads to increased beneficial delta (i.e., positive for option holders when stocks rise and negative for option holders when stock prices fall). Simply put: positive gamma makes the good thing better.

What About Negative Gamma?

If the scenario above pictures a beautiful image for the option holder, the picture should be the exact opposite for the person who sold the option, especially without a hedge. This trader faced negative gamma. If you are short one call option and the market declines, the rate of losing money continues to accelerate due to negative gamma. If you are short one put option and the market rises, the rate of losing money continues to accelerate due to negative gamma.

Making Profit with Negative Gamma

Why would a trader choose to take on the risks that come with having negative gamma positions? To make a profit, the underlying stock must move in three ways.

1. Move in the right direction (upward for calls, downward for puts)
2. Move quickly to prevent losing too much money to theta (time decay)
3. Move enough to overcome the cost of purchasing the option

This is a lot of movement, and most traders struggle to predict market direction without a timeframe. Unlike most traders, the option seller has a reasonable chance of making money, making negative gamma positions attractive. Warning: If selling options seems too good, be very cautious. Sometimes markets face unexpected price changes, and the option seller can get hurt. It is advisable to sell spreads rather than uncovered options. When trading negative gamma positions, use a risk chart to inform you when you are at risk of losing a lot of money or when the position exceeds your comfort zone. The Greeks – gamma, theta, and delta – can help you estimate the price that will issue the alert, helping you reduce risks and realize profits.

Source: https://www.thebalancemoney.com/the-greeks-trading-with-negative-gamma-2536618