Gamma hedging trading strategies : Part III

By , CEO of Volcube.

Some more notes on gamma hedging and trading strategies

The hedging time frame

Although gamma hedges are usually placed in the spot market a certain distance away (in other words, at prices above and below the current spot price), an alternative premise to a gamma hedging strategy is to think in terms of times frames. So for example, one might consider hedging hourly or daily or weekly etc.  There are black-box (i.e. automated) hedging strategies along these lines. Clearly it is simple to implement. All such strategies look to take the volatility out of the resulting profit and loss profile, by hoping to achieve an averaging effect. Variations on the basic idea of course are possible, in order to improve the results. For example, an hourly hedging strategy might be modified to allow for more breathing space during ‘hours’ that are expected to be more volatile. Suppose the strategy is to gamma hedge every hour on the hour. But suppose that a major economic announcement occurs regularly at a particular time, say 8.30am. It could be the case that hedging at 8am and 9am might be sub-optimal (or not; this will vary from market to market and over time and requires research, but the point is made to be illustrative). Better might be say to hedge at 8.35am for that hour to capture large price moves resulting from the announcement.

Learning options? Try Volcube for FREE

The most typical time frame for hedging is probably daily (on the close). In all likelihood, this just reflects the normalization of theta to be a daily decay number. If your theta bill (positive or minus) is represented as a daily figure, it probably does tend to make one think in daily time frames. But some traders do avoid this mentality and let their gamma hedging strategy run over multiple days. This will certainly tend to increase the volatility of the returns from gamma hedging (especially compared to a very ‘tight’ gamma hedging strategy such as an hourly approach). As we have noted in part I, the returns from gamma hedging are exponentially related to the distance the spot price moves. The spot price is more likely to move further over longer time frames. Therefore, running a gamma hedging strategy that extends over multiple days can significantly increase the size of the profit and loss.

Hedging by distance

Probably the most common hedging strategy. Picking spot prices a certain distance away and hoping to hedge at those levels before a certain time, typically the end of the day. Suppose the levels chosen are break-even (i.e. a gamma hedge at either level [up or down] will cover the day’s theta bill). If these are achieved early in the day, the trader can now look to actually profit from his gamma. Any further hedges will turn a net profit. So how to choose the level for these secondary levels? Options include trading ‘tighter’ to make lots of small profits as well as looking to score ‘home runs’ by working gamma hedges a considerable distance away.

Settling up on the close regardless of the result

A common approach, especially for those who view their gamma/theta trade off as a daily matter, is to gamma hedge on the close. The delta is neutralized, regardless of how far the spot has moved. The reasoning here is that there is a chance of a ‘gap’ move in the spot on the open the following day and this carries risk. Suppose our gamma hedge level was 50 cents below last night’s close. Sadly, we don’t get the gamma hedge and the spot looks like closing just 30 cents below last night’s close. In this case, we might be wise to hedge and re-zero our delta. This is because we might expect the spot to gap move tomorrow morning and if it moves 30 cents higher and we haven’t hedged, we will miss out on the potential profit from gamma hedging 30 cents below. Of course, it may open 50 cents lower and our hedge will have been in vain. Nevertheless, this again is a ‘smoothing’ technique to reduce profit and loss volatility.

A couple of great gamma hedging tips

  • If you are long gamma everywhere, remember to work some gamma hedges a long way away from the current spot price. Very occasionally, the spot price may gap suddenly up or down and then return to its prior price before  you have a chance to gamma hedge. Following this tip could prevent you from missing out on $1 million dollars, as happened to a colleague of mine when he failed to work gamma hedges a long way away at a time when he was long a lot of gamma everywhere.
  • Suppose you own gamma and the spot price has moved quite a distance but you have not yet gamma hedged. Now suppose you sell all your gamma via a new options trade. REMEMBER TO GAMMA HEDGE IMMEDIATELY! If you have accrued a position delta due to gamma when the spot price has moved and then you sell all your gamma, you now just have a large delta position. Failing to hedge this, could lead to steep losses if the spot returns whence it came. As the same colleague of mine once discovered to his grave disappointment.

 

Thanks for sharing this...

Question about Volcube?

Get quick answers from the Volcube Support team!

Support

Contact Volcube Support at any time on

[email protected]

Contact us

Email: [email protected]
LinkedIn: our company page
Twitter: @volcube

Copyright © 2014 Volcube Ltd.
All rights reserved