What is gamma trading?
By Simon Gleadall, CEO of Volcube.
Gamma trading is not simply the same thing as gamma hedging. Gamma hedging really refers to the act of executing a single gamma hedge, whereas gamma trading is more of a continuous activity. If we have a portfolio of options that has been delta hedged, then this will often only be a delta-neutral portfolio versus a single price in the underlying product. For example, imagine we own some calls and we are short some puts. To delta-hedge this option portfolio, we will need to sell some of the underlying. However, if the price of the underlying changes, then the delta-hedge we have executed is probably going to be inaccurate. This is because the individual options in our portfolio have gamma, which means that their deltas change if the underlying product price changes. So to remain delta-neutral, we will have to adjust our delta hedge. This adjustment to our overall delta is known as a gamma hedge. There is more on gamma hedging here.
Now, gamma trading is not quite the same thing. Gamma trading really refers to the idea of looking to gamma hedge profitably. For example, a trader may say “I want to buy some options so that I am long gamma, because I think I can make a profit by gamma trading the underlying”. What does he mean buy this? Well, what he means is that he thinks the price of owning the options day-to-day is less than the amount he can make from gamma hedging. Let’s break this down a bit further.
The value of options tends to fall over time. This is known as the time decay of options. As the options come closer to expiring, their ‘optionality’ diminishes. Out-of-the-money options at expiration are worthless, but before expiry they can have value because they may have a chance of expiring in-the-money. But as time passes, this optionality has to evaporate. So if one owns a bunch of out-of-the-money options, one can expect to see their value erode over time, other things being equal. The flip side to this loss of value through time decay is that by being long such options, one is long gamma. This is known as the ‘gamma-theta trade-off’. If a trader owns options, they can lose value gradually simply by time passing. But the trader can make a profit from owning these options by gamma hedging. Similarly, if a trader is short options, he can collect money as time passes, because the options he is short can diminish in value. The flip side for him is that he is short gamma and this can be a losing situation if the underlying moves.
Back to the original question. What is gamma trading? Gamma trading really refers to the idea of gamma hedging over time and looking to profit from this versus the time decay in the options. So, a volatility trader might say, “I’m going to sell some options, trade the short gamma and look to collect the time decay”. What he means by this is that he thinks that his short gamma hedges are not going to cost him as much as he is going to make from collecting the time decay from being short options.
We will look at why he might make such a decision in a forthcoming article on implied versus realized volatility.
Volcube is an options education technology company, used by option traders around the world to practise and learn option trading techniques.