In option trading, there are various techniques and approaches that can be applied to maximize the returns and minimize the risks. Simply choosing a suitable trading strategy as per your risk tolerance and budget would not be enough to get the best results. You need to understand various factors and their derivatives that affect the price of option premiums.
Gamma scalping is one of them and can be used to offset the impact of change in price in options trading. It is part of its other family members Delta, Theta and Vega also called Greeks. They are used to measure the risk and impact of these factors in the option price. Before we talk about how you can use Gamma Scalping in various options strategies like Iron Condor and Butterfly, let us know what is Gamma and what is Gamma scalping in the options market.
Topics Covered :
- What are Gamma Options?
- How Does Gamma Affect Option Price?
- What is Gamma Scalping?
- How Does Gamma Scalping Work?
- Gamma Scalping Example
- How to Use Gamma Scalping with Iron Condor & Butterfly Option Strategies?
- Gamma Scalping in Iron Condor Option
- Gamma Scalping in Iron Butterfly Option
- Summing up
What are Gamma Options?
Gamma measures the rate or speed of change of delta when the price of an underlying security changes. Gamma indicates how much sensitive option price is in respect to changes in the price of the underlying security.
The higher the value of Gamma, the more the delta is sensitive and will have more significant price changes, while the lower gamma means the delta is less sensitive and will have a smaller impact on the price movement on the option.
How Does Gamma Affect Option Price?
Gamma measures how much the delta of an option changes when the price of the underlying security changes by 1 unit price. If the gamma is higher it means, the option delta will change more sensitively to changes in the price of the underlying security. Whereas, a lower gamma indicates the delta of the option is less sensitive towards the price change.
When gamma is higher, the delta will change faster which means there will be higher fluctuation of option price when the share price changes. For at-the-money (ATM) calls and puts, gamma remains high, while for deep out-of-the-money and deep-in-the-money options, it remains lowest. But it remains negative for short positions and positive for long positions.
If you are able to understand and utilize the power of gamma, you can take advantage of price fluctuation to earn more profits from the market swings and volatility in the underlying security. You can adjust the option positions as per the change in the market conditions, this will also optimize your risk and enhance the overall profitability from option trading.
Recommended Read: What is Option Trading?
What is Gamma Scalping?
Gamma scaling is a unique style of trading strategy in which traders adjust their option strategies by buying and selling the options in a short time frame so that they can maintain the neutral gamma exposure and make smaller profits during the strategy.
Neutral gamma infers an option trade position in which the entire gamma value is almost zero. The main motive of gamma scalping is to make more but smaller profits from the price movement of the options by taking advantage of changes in the value of delta and gamma.
How Does Gamma Scalping Work?
The formula of gamma scalping is Δ = Γ * ΔS which shows the relationships between delta, gamma, and the change in the price of an underlying security. Gamma intensifies the impact of the price change on the delta of the option.
In this formula, Δ indicates the change in the option’s delta, while Γ represents gamma and ΔS shows the change in the price of the underlying security.
In gamma scalping, the traders do short-term options trading as per the change in the delta of an option position. When a trader considers implied volatility to become low, to make some profits they use to buy long calls and combine the same with a short position in the underlying security.
However, they can also buy long puts and combine them with a long position in the underlying security. However, the quantity of shares they trade should be relative to the delta of the option. It is not similar to when they trade 100 stock shares for each option position, that is usually known as the protective call option or protective put option.
Gamma Scalping Example
Suppose as a trader you have already a portfolio of options with a neutral gamma position. Here if the price of the underlying security increases, the gamma of the options will also increase. Here to maintain a neutral gamma exposure, you have to sell some options to counterbalance the increase in the gamma value. It will help you to secure good returns and maintain the desired risk levels.
While on the other hand, if the price of the underlying security decreases, the gamma of the options also decreases. Here in such a situation, you have to buy more options to maintain the gamma exposure. This will allow you to benefit from the decreasing prices and have better potential to get better returns from successive price changes.
How to Use Gamma Scalping with Iron Condor & Butterfly Option Strategies?
Iron Condor option strategy is composed of four options of the same expiration month, two calls (one long and one short) and two puts (one long and one short) of four strike prices. Buying a put out of the money (OTM), selling the put near to the money buying a call further OTM and then selling a call near to the money.
In the iron condor option strategy, you can earn the highest gain when the option price of the underlying security ends between the middle strike prices on the day of expiry. The main motive of the iron condor option strategy is to earn profits when the volatility of the underlying security is low.
Gamma Scalping in Iron Condor Option
An iron condor is a delta-neutral options strategy that can give you maximum profit when the underlying security doesn’t have significant movement. If you apply the gamma scalping in any strategy, you have to consider, the underlying security on the per unit basis of which option has 1.00 delta and a 0.00 gamma. Here using gamma scalping you can earn profit only when the delta remains neutral and the gamma remains positive.
Combining the gamma scalping in the Iron Condor, you have to buy calls or puts to hedge the position and use the tools to measure the changes in option pricing. The number of shares traded should be relative to the delta of the option. Here the role of gamma is to measure how much an option delta changes with respect to every 1 unit change in the price of the underlying security.
In Iron Condor, you took a position in four options of the same expiration. Here to use the power of gamma scalping you have to sell shares of the underlying security when its prices increase, and when its prices decrease you have the buy the shares. If you do this, whenever the price changes, means you are looking to buy the shares at lower price and sell them at higher prices.
Gamma Scalping in Iron Butterfly Option
As we got to know gamma scalping is the technique used in option strategy to take advantage of profits on every move of the underlying security. You can combine the gamma scalping with the Iron Butterfly option strategy while focusing on scalping as per the change in the price of the underlying security.
In the Iron Butterfly, the underlying securities having low volatility are considered for trading. You have to choose the expiration date, and then pick an at-the-money (ATM) strike and then keep an eye on it to keep adjusting your positions as per the price change.
As per your biased decision, if you think the underlying security might go up or down with slight movement. Suppose if price goes up before the expiry date, you can adjust your position to upper call or lower put strike prices as per the situation.
In iron butterfly, gamma scalping can work as a profitable strategy if the volatility and price gains of the underlying security from gamma scalping offset the premiums you paid for the option buying.
But if the market remains flat and the volatility in the underlying security remains less than the gamma implies, then your value of investment will decrease at a faster speed due to time decay than the profits earned from the gamma scalping.
Recommended Read: Butterfly Option Strategy
Summing up
Gamma scalping is a highly sophisticated option strategy mainly used or implemented by institutional investors and hedge fund houses to manage the portfolio of large investments in equities and futures. It is a very complicated trading technique, often used by highly experienced and professional traders to capitalize the market movement.
The strategy involves the adjustment of trade position in an existing option strategy to utilize the smaller movement in the price of the underlying security that affects the premium price of the option. You can benefit from smaller movements using the long gamma scalping and continuously re-hedging the delta exposure in the security.
Following the gamma scalping, you have to reposition your trade positions to maintain the balance of gamma exposure due to the frequent buying and selling of options your transaction cost will also increase, which will also affect the overall profitability of the option strategy. Hence, choose the right broking house like Religare that can offer you the low-cost brokerage in option trading helping you to reduce your transaction cost and maximize the returns.
Learn More About Derivatives Trading