Papale on Gamma Scalping

Summer is state fair season.  If you are headed out to one look for some of these treats:  caviar-covered Twinkie (Minnesota), Mac-and-cheese cupcake (Minnesota), deep-fried Oreo burger (Florida), deep-fried gummy bears (Ohio), deep-fried beer (Texas) — and old favorites such as chicken-fried bacon (Texas), spaghetti ice cream (Indiana), Krispy Kreme chicken sandwich (California) and the hot-beef sundae (Indiana, Iowa).

A few questions came up this week about gamma scalping.  Gamma scalping it seems has taken on almost a mythological reputation.  That gamma scalping is some secret strategy that once revealed allows for sure fire profits with little or no risk.  Now I know we all know better but let me do a quick review of what gamma scalping really is.

Gamma as most of us know is the rate of change of delta for a given change in the underlying.  So as markets move around, deltas change.  Gamma scalping is nothing more than a trader basically adjusting his delta as markets move.

For example, assume I am long 10 MSFT 46 calls.  Let’s say the stock is $46 so the delta of the calls are .50 giving me an option delta of +500.  As a hedge l decide to sell 500 shares of MSFT at $46 leaving me with an overall position delta of 0.  Now say the stock rallies $3 to $49.  The delta of those calls now are say .90.  That means my option delta is .90 x 100 x 10 = 900.  When I put the trade on I sold 500 shares at $46 so my overall delta is now +400.  This increase in delta is due to gamma.  Scalping the gamma would now have me flatten my delta position by selling 400 deltas.  That could be by selling shares or calls or even buying puts.  Now assume the market changed its mind (that never happens!) and the stock goes back down to $46.  Now my option delta is back to +500 because the calls are back to at the money.  But my stock delta is now -900 giving me an overall delta of -400.  To flatten up I need to buy 400 deltas.  The idea is I can sell deltas high and buy them back low.  Makes sense.

However there is a cost.  That cost is theta.  In order to perform this strategy we have to be long gamma and that means being long options.  When long options the time decay is working against us.  So in order for this strategy to be profitable we need an underlying that is moving around quite a bit.  The profit we make on buying  and selling stock needs to pay for our time decay in the long options we have.  If not, the profit from the scalps will not cover the cost of theta.




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