Option Strategy: Long Gamma, Short Vega

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To make money in options trading it's not just stock selection that can cause risk, but short gamma trading option strategies option selection Many seasoned option traders will forego the riverboat casino that is options expiration and only trade options that have more than 2 weeks left to expiration.

This holds especially true for "income" type trades that are short gamma by short gamma trading option strategies if you try and milk out every last penny of an income trade, you will run the risk of getting cut by the gamma knife edge and letting profits turn to losses in the blink of an eye.

The same siren song can occur for directional option traders. You may look at near term options and say they are "cheap" and offer plenty of leverage for the cost. But odds are you are neglecting the theta cost of those options, and the actual odds that you have on the position. Or flip it around, you could think that since an option has a theta of with 4 days left to expiration, that somehow you'll be able to make 50 bucks a day just by selling those options, without any respect to the gamma risks in selling short term options.

The desire for newer traders to trade short term options is compounded by the fact that weekly options short gamma trading option strategies become much more widespread in many options, so every week can behave like options expiration. We'll dive a little further into option greeks so you can get a better understanding of what risks you take when trading short term. Gamma is a stock option greek that makes options trading so fun.

It can be referred to as the "acceleration" of the option. If you are long gamma, you want fast moves; if you are short gamma, you want the underlying not to move at all. It's also known as the second derivative, which doesn't mean much unless you are viewing a risk graph:. Gamma is a wonderful thing, and it is directly related to the amount of time decay available in an option. You can consider gamma to be like fire: But if it gets out of control, it can be short gamma trading option strategies very destructive force.

What does this tell us? On out of the money options, the gamma will start to decay, as those options lose their effectiveness. But as we approach options expiration, gamma drastically increases on at the money options. This increase is what I affectionately term the "gamma knife edge," and it's where many new option traders get cut.

Remember how I said gamma and theta were linked? Here's a chart of theta over time:. So not only do you have a significant increase in gamma, you also have a much larger amount of time decay in options.

Funny things start happening to options as we approach expiration. The pricing models start to get a little weird, and you could short gamma trading option strategies be taking on more risk than you thought-- regardless of whether you are an option buyer or seller.

Regardless short gamma trading option strategies your trading style-- if you are a new options trader and just beginning to short gamma trading option strategies the mechanics of the options market, stay away from short term short gamma trading option strategies. Opex trading and dancing around the gamma knife edge is a dark art that requires a level of agility that isn't often seen in new option traders. Short Term Risks Many seasoned option traders will forego the riverboat casino that is options expiration and only trade options that have more than 2 weeks left short gamma trading option strategies expiration.

This point leads me to the next principle new option trades should follow: Don't Trade Close to Expiration We'll dive a little further into option greeks so you can get a better understanding of what risks you take when trading short term. The Gamma Knife Edge Gamma is a stock option greek that makes options trading so fun. It's also known as the second derivative, which doesn't mean much unless you are viewing a risk graph: Where It Gets Tricky The chart below shows the gamma of a call option buy, plotted over time: See the other side Remember how I said gamma and theta were linked?

Here's a chart of theta over time: Let's move on to the next lesson so you don't treat the market as a casino

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Ocassionally windfalls [applicable to overhedges] also contribute to the PnL. The trading strategies of the desks to a large extent center around the gamma and the volatility exposures based on the market view they have. In this article we shall try to understand the gamma risks. While being long gamma requires funding costs i. So by being long gamma you would realize negative PnL on theta whereas positive PnL on theta by being short gamma [well almost always - one exception being long deep ITM puts are long theta].

One common practise is to be long gamma in trending markets and short gamma for ranged bound or sluggish markets. In the discussion that follows we assume that the portfolio is delta hedged at discrete intervals. Of course if we keep the portfolfolio continuously delta hedged, we would not realized any PnL [the argument assumes that the other risk factors do not change] i.

It will be worth noticing in the discussion that follows how the perspectives of the risk managers and traders sometimes may be often differ. Lets take the first scenario, the market is rallying stocks moving up. The traders would like to have long gamma exposures in such a market. With a long gamma exposure, as the markets rally the portfolio picks up more delta between rehedgings.

To keep the portfolio delta hedged as the market moves up and the portfolio picks up positive delta, the trader will sell the stocks [or forwards]. With markets going up the trader is selling at a high [sell at a high while have bought at a low] thus making profits.

When the trader expects that the market will continue to rally, he would delta hedge less often to be able to accumulate more deltas [and hence more profits]. In another situation we suppose that the markets were crashing , the trader would again like a long gamma exposure. The portfolio would be picking up negative delta which the trader would cover by buying stocks [buying low] in a falling market.

The trader is making a profit in this situation by accumulating negative deltas on the way down. It would start to appear that being long gamma always gives you a profit. Remember that we told that positive gamma is an expensive strategy because of the time decay.

To be able to earn profits overall, the stock movements should be able to compensate for the loss in time decay. So when the trader believes that the market is going to be sluggish [small moves], he would keep a short gamma position and be happy to earn PnL due to theta.

But, being short gamma is a risky strategy. The trader will start loosing money in trending markets. The analysis is similar to the discussion above, when the market crashes the portfolio picks up positive delta and the trader will find himself in a situation where he is selling when the market is crashing [selling low].

Similarly when the market rallies, the portfolio would pick up negative delta and the trader would find himself in a situation where he's buying in the peaking market to delta hedge. In a collapsing market the traders sometimes might like to hedge less often in the hope that the market would rebound [after all you dont realize profit or loose unless you book it]. But then the risk manager should know that this strategy runs the risk of realizing even more losses in future by not booking small ones today.

Hence short gammas can get the risk managers worried. A physicist thinks reality is an approximation to his equations. A mathematician doesn't care. Gamma exposure and risk management 3. I have my own problems to solve. I'm never likely to go there. I am just short the profit at the moment.