Options

As a mentor and former market maker, I get asked all the time “How should I scalp gamma?” It is a surprisingly difficult question to answer. As a market maker, I had very few constraints on my trading activity. I could hedge a back spread any way I wanted. If I wanted to hedge by selling stock, that was simple. I pulled up my stock execution system and unloaded the underlying. If I wanted to trade options against the gamma, I could trade just about any option in the spectrum. If I thought there was more edge in trading the January 2012 month to hedge a front-month back spread, I would. If I wanted to hedge calls with puts, or puts with calls, that was also not a problem. 
 
Retail traders lack the ability to trade and execute many hedging strategies. I soon realized it really doesn’t matter what the trader uses to hedge. It matters how the trader hedges. While there are endless options to scalp gamma, there are two ways I teach students. One method is for very active traders that I call “pay the decay,” and the other is for less-active traders and I call “delta/gamma ratio hedging.”

Pay the Day

When I first started teaching gamma scalping, the only method I taught was “pay the day.” This is an intense and involved form of scalping and is probably more useful for full-time traders than retail traders. All traders should understand the technique. 

The trader uses theta of the position to calculate his daily “nut.” The trader uses the formula for change in slope to calculate how much movement is needed in the underlying to “pay the decay.” 

Looking at the blind straddle on October 16, 2009, the position is long 8.25 gamma and short 6.09 theta. The trader would plug in 7/5*6.09 as the solution (7/5 to take the weekend decay somewhat into account), and use the gamma as the change in slope for the curve. The variable the trader is solving for is the change in price. 

The formula ends up looking like this:

7/5 * Theta = 0.5 * Gamma * X ^ 2
  
Or solving for X:
X = SQRT (  7/5 * Theta / 0.5 * Gamma )

Which reduces to:
X = SQRT ( 2.8 * Theta / Gamma )

Solving the equation in this case:
X = SQRT ( 2.8 * 6.09 / 8.25 ) = $1.43767

The SPY needs to move $1.44 in order to cover the theta decay for that day. This formula has to be rerun every morning as decay and gamma change (both get larger every day). A major complaint is that anyone who has a “real” job may not feel like doing this calculation daily. There is a much bigger problem with this formula though:

It doesn’t answer when to adjust. 

Most of my students assume that they should set the scalp $1.43 from the previous day’s closing price. Not the case! Setting the scalp that far will only get hit about once every three days. 

Personally, I set my scalps at 50% of the required move and sell all of my deltas at that point. Then I buy them back when the stock moves back to unchanged. This creates two scalps that equal 72 cents of movement. I have to make this type of scalp twice, either round tripping the underlying moving 72 cents twice, or getting a combo of round trips to the upside and the downside. 

At day’s end, I always zero out deltas.

If the underlying gaps past the required move, I sell all of the position’s deltas (or at least 75% if I think the move could continue). 

If the underlying hits a scalp and continues to run in that direction, I use the scalping point as my new starting point. This method requires a lot of work and can be very frustrating when the underlying really runs. (I’ll be honest, if I sense momentum, I will let the underlying run and set trailing stop orders instead.)

This type of scalping will certainly cover a portion of my decay and is surprisingly far more likely to cover my decay then setting the scalps $1.43 apart.   

Why? Volatility predicts price movement, not direction. 

Scalping gamma at closer intervals, I end up making far more scalps than setting the scalps further apart.  When I was on the floor and trading Sun Micro Systems, there were times where I would scalp ten to 30 times in a day.  By the end of the day, I could have thousands of dollars in my pocket, even if SUNW (the old symbol) didn’t move. One of the neat things about long gamma is that the trader wants to get in as many scalps as possible. This method allows for that.

There is more to this method, and I will write a Part 2 for MoneyShow.com readers soon.

By Mark Sebastian of OptionPit.com

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