Why is the gamma risk limits tied to the theoretical profit, and not the position gamma?

This is because of the third derivative Greek sometimes known as Speed. Speed is defined as the change in gamma with respect to spot prices. Risk managers tend to reason that looking at net position gamma could be misleading; a portfolio could be long gamma versus the current spot price; if that was all there was to the position, that might be thought zero risk (aside from theta risk, since no money can be lost from being long gamma per se). However, if the position gamma with the spot say 2 points lower is negative (perhaps because the position contains a 1 by 2 ratio put spread), then the risk is definitely not zero. So most risk managers just look at the change in theoretical profit over a large move and use this is a proxy for the net gamma exposure across a range of spot prices. It makes intuitive sense to do that because over large moves, the net gamma profile does tend to dominate the change in p&l. As Volcube is wherever possible and sensible built to simulate the real options trading world, we also tie the in-game gamma risk limits to theoretical profit and loss and not just the net position gamma.

 

 

 

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