By Steve Papale
I like sports movies. Last night we all sat down and watched “Secretariat”. I had seen the movie a while ago but one of my sons had never seen it. I was around 13 in 1973 when Secratariat won the triple crown and vaguely remember all the attention, even as a young kid who had little interest in horse racing. But after watching the movie and the over the top domination of the Triple Crown, especially the Belmont, to me Secretariat should go down as one of the greatest athletes of all time. Check out the movie if you haven’t seen it.
Premium sellers have one overriding desire – that markets stay well behaved, that is don’t move around too much. Any condor, butterfly or other short gamma, long theta strategy traders understand that. We want to collect our time decay and not have to deal with our deltas getting to large due to extreme moves in the underlying.
Of course, the long gamma trader has the opposite desire – he wants markets to move, the more the better. Theta for him is an out of pocket cost that must be covered every day. So basically no matter what trading strategy you use, theta and gamma are the opposite sides of the same coin. The ying and the yang. Salt and pepper. Bogey and Bacall. You get the idea.
For the short gamma trader, as we said, theta is our reward, negative gamma is our risk. Say a position is collecting $100 per day in time decay. If we were to “scalp the gamma”, which basically means adjust deltas as necessary to keep them relatively flat, we would want this cost to be less than the $100 we would collect from theta. Remember the negative gamma adjustment causes us to buy high and sell low.
For the long gamma trader who is paying $100 a day in time decay, he wants his gamma scalps to be more than his $100 cost. His positive gamma means he is buying low and selling high. So as markets move day in and day out, ignoring any changes in implied volatility, our traders, in theory at least, will be managing their position deltas and overall P/L’s will reflect all activity.
Let’s assume then each trader carries their position until expiration. If the short gamma trader has a positive P/L, than movement, if adjustments we made consistently, was less than the implied volatility indicated when option was sold, hence the option was priced higher than fair value. If on the other hand, the long gamma trader has a positive P/L, then movement in underlying caused greater adjustments and his option was purchased below fair value. If both traders have 0 profit or loss (ignoring commissions and transaction costs) than the option was priced at fair value when trade was made. At the end of the day, the option seller is trying to sell above fair value and the option buyer is trying to buy below fair value.