Gamma Scalping Strategy
Scalping a unique trading style where a trader tries to make a small profit by buying and selling considerable securities in a short time frame. Now, in this section, we will learn an option trading strategy using one of the option-greeks called ‘Gamma Scalping.’ So, let us begin:
As stock prices in a portfolio keep fluctuating, it requires adjustments in order to keep its delta neutral. For example, if a trader buys call option, he will go short on stock to hedge his position. But when it comes to large portfolios which follow a delta neutral approach, occasional adjustments will be required to keep it delta neutral.
A very systematic approach to these adjustments is "gamma scalping" or "gamma hedging." Gamma scalping is not an individual strategy - rather, it is layered upon a volatility strategy.
There are traders who use "scalping" as a standalone strategy just to make small profits with price fluctuations. However, scalping gamma is different. It is hooked around delta adjustments in an option portfolio.
Imagine a large portfolio that consists of both long and short premium positions. Long premium positions will want the underlying to move a bit, while short premium positions will want the underlying to be stable.
In other words, the risk involved with the long premium position is lack of movement, while the risk involved with the short premium position is significant movement in the wrong direction. These risks can be reduced with the help of gamma adjustment strategy.
A long premium position is the basis of true gamma scalping. Due to the positive relationship between underlying price and delta, your position delta will decrease when the underlying moves against you and increase when the underlying moves for you. As this happens, you “gamma scalp” your position by adding stock position whether long/short to bring the overall delta back to zero. The objective here is to neutralize the cost of theta on the long premium position. Elections, earnings, economic data etc are all good reasons to think that the market can give a potential move and the exact time to initiate a true gamma scalp strategy.
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Let us take an example of a long straddle:
Gamma Scalp Setup:
- Buy a Straddle (Long Call + Long Put)
- Perfectly Data Neutral
If the underlying falls: Add a long stock
If the underlying rises: Add a short stock
We start by buying a straddle (call and put option of the same strike price), expecting the market to either go up or go down. So to start off, I have a delta neutral position. When the market goes down, according to gamma scalping, my delta is now approaching a higher negative value because of the put. The negative delta of Put is going to overshadow the delta of long calls. To restore to a delta neutral position, I will add stocks to add delta and thus making delta neutral again. Similarly when the underlying rises, the call delta increases and the entire delta of my position heads to become a positive value. Thus, to restore my delta neutrality, I will now sell the stocks to get a negative delta. It will again help me re-establish a delta neutral position. The reason behind this continuous adding and selling of stock to maintain delta neutral position is theta. We are long on straddle and theta is acting against us every single day. If the price of the underlying doesn’t move, we will lose time value on both the long options.
Imagine a trader has bought 100 lots of Nifty 17000 CE when Nifty is trading at 16000. The premium for this call is ₹60. Delta of this option should be close to 0.25. The delta of the position is (0.25*100)= 25
In order to be delta neutral, he will sell 25 lots of Nifty. If Nifty rises to 16500, the delta of this call option will range approximately at 0.4. So now the total delta of the option position is (100*.4) = 40 which means he will have to sell 40 lots of Nifty. He has already sold 25 lots, so now he has to sell the remaining 15 lots at the price of 16500.
Selling these 15 lots is gamma scalping in action. This adjustment makes the portfolio delta neutral and also gives a chance to profit if Nifty again lowers to 16000. This back and forth adjustment or scalping produces extra income to help cover the cost of theta.
There is no fixed solution as to when these adjustments should be made because it depends on the risk profile and adjustment strategy of an individual.
Let us consider a situation when Nifty is trading at 16500. You buy 100 lots of straddles at a strike price 16500. The 16500 CE is trading at ₹370, whereas the 16500 PE was trading at ₹400. So the total straddle value that you pay is (370+400) = ₹770
So the breakeven points for you are (16500-770)= 15730 and (16500+770) = 17270
Combined Theta for this position comes to -10.75 (as derived from the Black–Scholes model option pricing calculator). This means that this entire position is going to cost you ₹10.75 daily as the premium erodes while you wait for Nifty to make some move.
Say, after four days, Nifty bounces up to 17000 level. So now the price of the call is ₹640 whereas the price of the put is ₹185. This brings the straddle value to (640+185) = ₹825
So clearly we gain on straddle because we bought it at ₹770/- and now it’s worth ₹825/-.
Now the position delta here is, call delta= 0.7 and put delta=-.3 which comes to a delta of 0.4. Trader had bought 100 lots, so his delta is 0.4*100 = 40
To gamma scalp and establish a delta neutral position he will sell 40 lots of Nifty.
Now let us assume after seven more days have passed and Nifty is again trading at 16200 level. Now the straddle value will be (210+440)= ₹650/- (call premium now becomes 210 and put premium 440).
Now we lose on straddle which was bought at 770 and now trades at 650. But we gain on Nifty because we sold it for 17000 and it now trades at 16200. So profit on Nifty is 800*40 lots = 32000/-
Delta of the position now: call delta =0.4 put delta = -0.6. So net delta = -0.2*100=-20
To neutralize this position we will buy 60 lots of Nifty. (40 to square off and 20 to neutralize delta).
As four more days pass and Nifty slides further to 16000. Now the straddle value comes to (120+560)= 680. We still lose on the straddle. We lose on Nifty (20*-200)= -4000 but we gained 32000 from the previous Nifty trade.
So here we see when the Nifty does not move much we tend to suffer losses. The best case scenario for us will be the underlying to explode in either direction, when buying a straddle. Another scenario suitable for us will be heavy continuous price swings. This is so because it helps add short delta at the top and positive delta at the bottom. This process of buying low and selling high, obviously helps to make more money and effectively the long straddle becomes free. Now, we have no fear of losing premium money.
Another scenario is where the underlying barely moves and doesn’t give the opportunity to scalp gamma.
Reverse gamma scalping is very much the opposite. Here you start with a short premium position, like a short straddle. You scalp the short-term price swings in the underlying, but in a completely different method. Instead of buying when the price falls and selling when the price rises, you actually buy when the price rises and sell when the price falls. This is because the short gamma with the short premium position makes you bearish on the way up and bullish on the way down. Therefore, you continue to work to neutralize your delta, and you’re willing to give up some of your positive theta in exchange for some risk reduction on your naked options.
In both the cases, the objective was to scalp around the original position. The two reasons why we scalp? The answer is to neutralize delta and adjust theta.
