Gamma Trading (or Variations Of)

[SIUYA 11]

This thread is for those who wish to discuss gamma trading. (I have tried to keep the definitions simple, and then offer more reading for those inclined, and possibly a simple knowledge of options and greeks is required)

Please dont get caught up in - it does not work, this is not how you do it...etc. If you understand it, the pitfalls, advantages and disadvantages and folks can point those out then perfect.....also be aware different instruments have other issues such as skew, dividends, futures rolls. This is ideally for context and everyone will have variations of experience.

 

...........................

 

What is Gamma?....

 

It is a measure used in pricing/trading options. Commonly known as one of the 'greeks'

 

It measures the rate of change in the delta with respect to changes in the underlying price.

ie; It shows how much the Delta (another greek) is expected to change as the underlying price changes.

 

What is Gamma trading?.....

 

Gamma trading is a process whereby the trader continually rehedges the positions/book/trade delta with the specific the aim of profiting from this activity.

 

the best definition I could find is here http://www.volcube.com/resources/options-articles/what-is-gamma-trading/

 

There are variations of what people may or may think they do, or how they approach this, but in keeping it simple -

 

A trader when continually rehedging an option position in this way is specifically trying to capture the movement of the underlying in order to scalp/job/rehedge in order to pay for the time decay of the option. They are continually rehedging the Delta.

 

By doing so they are effectively wanting to capture more of the volatility component of the underlying movements than the volatility component of the options they paid for.

(To keep it simple - let stick with long options only - short options will only complicate the matter, and gamma trading usually only refers to periods when you are long volatility or purchase options.)

(For clarity - this is different to delta hedging - an initial and then occasional hedge of the delta in order to keep delta risk down, a gamma hedge - an offset as part of the delta hedge or a hedge against other gamma or volatility trading - an outright view on the movement of the volatility component of the option prices.)

 

Good reading....

http://www.surlytrader.com/trading-gamma/

http://www.optionsplaybook.com/options-introduction/what-is-volatility/

 

How does this work?.....

 

The easiest way to show is in the use of a simple example over a period of time.

 

Buy 100 calls, at the money with a delta of 50. (0.50) and hedge by selling the underlying 50 times.

 

Period 2- underlying moves up and the Delta is 0.60. To hedge you sell - open position is short 60

Period 3- underlying moves up and the Delta is 0.65. To hedge you sell 5 - open position is short 65

Period 4- underlying moves down and the Delta is 0.55. To hedge you buy 10 - open position is 55

Period 5- underlying moves down and the Delta is 0.40. To hedge you buy 15 - open position is 40

Period 6- underlying moves up and the Delta is 0.30. To hedge you buy 10 - open position is 30

 

Whats the point of this?.....

 

You have sold and bought the underlying and ideally this will show a profit as the underlying moves up and down in a range of some sort. (dont worry about range or trend etc)

However the offset is that the options have decayed. Hence you will have a loss of the time decay. Which is why you are trading the actual volatility of the underlying that you can capture v the implied volatility that you paid in the original option price.

(If you think you can intra-day trade like this then think of the time decay as being the time decay of the options price+commissions+spread....... it is possible but IMHO unlikely)

 

this section below is likely to be expanded via discussion....

 

What are the advantages of this? ....

You dont really need to take a view on direction. You simply need to capture more volatility than you paid for.

 

What are the disadvantages of this? ....

 

As there are few free lunches, its not that easy - costs, spreads, time decay usually mean most options are priced accurately enough to ensure its harder to capture this...(and IMHO in many instruments, the skews probably mean that implied prices are often higher than the historical movements because of the risk of black swan events etc - but this is pure conjecture on my behalf and can be discussed later also) Time decay, and being able to capture the moves provides the same issues as for most strategies (I would say 'discipline' is less likely an issue here as you are simply re hedging)

 

Thats enough for one post....

Edited July 29, 2013 by SIUYA

[Seeker 11]

As I see it, any vanilla option position, long/short some calls/puts is conceptually equivalent to a position in the underlying asset. Non-vanilla options are a separate issue.

 

This is clear since, the entire point of delta hedging is to eliminate the risk of changes in the value of the option by investing in the underlying to make yourself delta-neutral. The fact that banks can (and do) do this indicates the equivalence.

 

The reason I point out the equivalence, is because some may think you are getting something different, or new, that couldn't be achieved by investing in the underlying. Typically (though not always) you will be creating a position that you could equally do for less transaction costs, by just investing in the underlying (i.e. no options needed at all). It's often a little bit like going long and short the same instrument and paying twice the spread you need to.

 

That said, options have their own market, and markets can get out of line. But you should be aware that you could create (funds permitting) the same position via the underlying, and so there really is no reason to get into vanilla options unless for cost reasons, because the market is out of line, or because you don't have the funds to achieve the respective position in the underlying. The last of these is probably not a valid reason either, but I state it anyway, the second will be capitalised on by algos before you can, and the first is unlikely since trading options is usually quite expensive, and more so than trading the underlying.

 

I look forward to other traders pointing out why one would wish to trade options rather than take an equivalent position in the underlying.

[ticks 10]

Thanks Siuya. This no doubt should be the proper place for this thread.

 

But alas I just noticed this surprising statistic:

85,600 Registered Traders

Welcome to our newest member, Traderminute

Now online: 13 members and 130 guests

 

That appears to indicate very few possible contributors as the membership is not very active.

 

But lets hope you get quality responses from the limited audience.

 

Great and useful topic. It is profitable if done correctly, Anyone with options experience can do it, But the nay-sayers probably have chased them all to a simple-simon approach to trading that will not really work.

 

Best to you...

[veAL 10]

Hi Siuya,

 

nice read!

I suggest trading the delta hedge is a matter of historical volatility (in the option priced volatility) beeing less than implied volatility to be profitable. For this there has to be a day with higher volatility to be profitable. In general we can say one day in a week we have a wide ranging day, so to be profitable all depends on such a day. So the calculation is based on a probability of 1 out of 5... For a question of riskfree income there is the question if on one day the profit is higher than the losses of the other 4 days. Perhaps we should do the work looking at real market examples...

In my opinion trading directional moves with long delta strategies is probably a higher probable outcome. You can start out very small, choosing the options with high volume diminishes your trading costs... tighter spreads, and the insurance rate is a calculated risk position (long call / long put). Another plus is if you close out the position at the end of the day you do not have overnight risk, no gap opening.

Maybe I should start trading options again...

 

Thank you

veAL

[SIUYA 11]

As I see it, any vanilla option position, long/short some calls/puts is conceptually equivalent to a position in the underlying asset. Non-vanilla options are a separate issue.

 

This is clear since, the entire point of delta hedging is to eliminate the risk of changes in the value of the option by investing in the underlying to make yourself delta-neutral. The fact that banks can (and do) do this indicates the equivalence.

 

Yes - keep it to simple vanilla options.

 

As for creating the same position - this is nothing to do with it and should not be confused with it.

When trading gamma - you are always hedging and hence depending on when your time frame for hedging is (intraday, daily, % move) you are not really trying to replicate a directional position. You are trading your ACTUAL volatility captured v IMPLIED volatility paid for.

(Now also understand the difference in volatility - usually historical volatility is usually measured daily, implied vol is the expected future volatility and actual volatility captured is your own personal skills in capturing the smaller moves)

 

If you want to trade directionally then yes trade directionally - this can help as it allows you to 'lean on the deltas'. (This is an expression I have used, and picked it up many years ago even though I dont think its widely used)

 

Basically - if you are bullish and you have a position that the delta is getting longer as the price moves up. (happy smiley payoff of long gamma) then you can choose to rehedge the long delta at a higher price, or a later time - ie you can lean on your deltas.

eg; if you normally rehedge at a certain price level but you are bullish and a breakout has occured you can choose to let the deltas run a little longer. (Only do this once you have reasons to of course)

 

.......(The happy smiley payoff of long gamma: - this is because when you have a hedged position, or both puts and calls, your payoff diagram makes money when there is movement - so when using a payoff diagram with price on the horizontal axis, the PL on the vertical axis will show a happy smile. Short volatility strategies show an unhappy smile when there is movement)

 

 

The reason I point out the equivalence, is because some may think you are getting something different, or new, that couldn't be achieved by investing in the underlying. Typically (though not always) you will be creating a position that you could equally do for less transaction costs, by just investing in the underlying (i.e. no options needed at all). It's often a little bit like going long and short the same instrument and paying twice the spread you need to.

 

That said, options have their own market, and markets can get out of line. But you should be aware that you could create (funds permitting) the same position via the underlying, and so there really is no reason to get into vanilla options unless for cost reasons, because the market is out of line, or because you don't have the funds to achieve the respective position in the underlying. The last of these is probably not a valid reason either, but I state it anyway, the second will be capitalised on by algos before you can, and the first is unlikely since trading options is usually quite expensive, and more so than trading the underlying.

 

I look forward to other traders pointing out why one would wish to trade options rather than take an equivalent position in the underlying.

 

 

Generally many traders might be better off trading direction rather than options gamma, but the only way you get the equivalent position is with a synthetic of a put/call at the same strike and series - the rest is a simply having a different risk return payoff and this is important to understand as ----

--- you can loose money trading this way, even if you get the direction right!

--- you must understand what your risks actually are.

--- you must keep in mind the trade off between gamma and time decay

---- if you get the hedges horribly wrong you can loose money....and yes you can loose more money than the total price of the options you purchased. There are rare circumstances this can occur. However - the trade off is what you can make when you get it right, or when outsized 'black swan events occur'

 

Which is why taking Seekers point it is important to remember - what you are trying to actually do - and what the costs are.

 

Remember the hedging - gamma trading is the continual rehedging - you basically are trying to capture the moves in the underlying with this and in doing so you are trying to capture MORE volatility than the IMPLIED VOLATILITY component of the options you purchased.

However - this is one of the problems - if you dont capture more, and this has to cover your commissions as well you will loose. Its simple maths in this regard.

 

.........................

As to why use options?

 

If you trade the gamma - it takes a focus and time that is different to some styles because time decay waits for no one, crossing spreads is expensive and capturing extra actual volatility is crucial. However....

if you are not good at picking direction but are good at determining a move might occur,

if you wish to use extra leverage when expecting a move,

if you are prepared to use options and spend the time covering costs and waiting for outsized moves (IMHO - this is where the real value is)

 

to do this effectively I would suggest you need more money than most would expect.

Why - costs will kill you, contract sizes for exchange traded options mean you need to have enough trade size on to be able to effectively cover the costs and make the rehedging worth while. (Try this on one contract v trying on 100 contracts)

I also think you will be hard pressed doing this intra day - I would like to hear from those that do. - and have to view this as a longer term process.

 

.....................

(please excuse the capitals and underlines - used only for emphasis and I will try and answer any questions - not directed to the poster but for general reference - so if you are offended if i disagree - sorry it is not personal its simply more in the spirit of discussion and education for anyone.)

[SIUYA 11]

Hi Siuya,

 

nice read!

I suggest trading the delta hedge is a matter of historical volatility (in the option priced volatility) beeing less than implied volatility to be profitable. For this there has to be a day with higher volatility to be profitable. In general we can say one day in a week we have a wide ranging day, so to be profitable all depends on such a day. So the calculation is based on a probability of 1 out of 5... For a question of riskfree income there is the question if on one day the profit is higher than the losses of the other 4 days. Perhaps we should do the work looking at real market examples...

In my opinion trading directional moves with long delta strategies is probably a higher probable outcome. You can start out very small, choosing the options with high volume diminishes your trading costs... tighter spreads, and the insurance rate is a calculated risk position (long call / long put). Another plus is if you close out the position at the end of the day you do not have overnight risk, no gap opening.

Maybe I should start trading options again...

 

Thank you

veAL

 

Yes - its a trade off between what actual volatility you can capture v what implied price you pay.

 

eg; You buy and option cost $100 - it is ATM (the underlying is $1500 and strike is $1500) and hence lets assume there is no intrinsic value - its all time decay. Lets assume there is 100 days until expiry.

 

On average you will need to capture more than the $1 a day. (Due to the slope/rate of decay changing this will be likely only $.3 a day early on, and $3 a day later on -- More detailed Greek analysis is required - beyond any scope here and individuals can read this themselves)

However the point being..... every day the underlying might move up and down around the strike but still close there every day at the strike.

Historical volatility might be zero

Actual captured volatility might be $.50

Implied - irrelevant as you have already purchased, unless you wish to then sell out the options again, and then this becomes a trading spread cost and you have in fact traded volatility as opposed to trading gamma.

 

....................

As for closing out at the end of the day.

I would not - I think the strategy works best when you take a longer term view. (I pointed out my reasons in the post above - costs, spreads)

The most important being - YOU BENEFIT FROM GAPS BEING LONG VOLATILITY

 

Veal unless I am missing something from what you said (I assume you are talking about closing out your options at the end of the day) - I think maybe you are missing the value of long volatility gamma trading....you want gaps, you benefit from movement....you pray for disaster!

 

Otherwise, if trading direction then yes you can eliminate gaps risk - you also eliminate gaps that do in your favour.

 

..............................

As for real world examples..... I currently dont trade options - I dont want the focus anymore - trying to capture the moves like that is intensive - best left to 25yrs olds IMHO. If you think its mentally draining while trading imagine buying and selling continually just to break even, watching time decay eat your PL every day....it can be depressing - the good times are great, but the daily grind you can get sick of. The money was made in a small period of time, you never knew when, you either went on holidays and never really relaxed or were pissed off when you got back. Lots of little pain in the butt trade offs.

 

I used to trade as an equity option market maker and can give plenty of old examples related directly to stocks (these have different issues other than futures - dividends, short borrowing)....and would also be happy to comment or help on live examples if other have them.

[ticks 10]

SIUYA please see a PM that I sent you. Thanks

[ticks 10]

Most traders will find this discussion and information rather complex.

 

Please understand that one need not know how an automobile engine provides the power to drive the car. So you don't have to be a full-on auto mechanic or engineer to press the accelerator and steer the car.

 

This is really a simple trade to understand and "drive". The danger is to get too caught up in the details. If there really is enough interest here to delve into to this profitable strategy then we can perhaps get to the "nitty-gritty" of how simple this is.

 

My concern is how few participate. On the TL start page it shows 85,000 plus members but where are they? No one seems to post except for a few "regulars". The reason I point this out is that it takes time and effort for those who post and it seems rather fruitless to put out information here.

[ticks 10]

Flickr: assettight's Photostream

 

Trying to post some examples . Here is a trade I have on now.

 

(ls there a way just to post a chart here as an image or must i put it to a URL?)

[ticks 10]

If you have questions on how to read the above post please ask and I will try and post some explanation that will clarify. But if you know how to read this picture and enlarge it then you should learn most of what you need to know to trade like this.

[ticks 10]

Here is a follow up pic and so can see it is now more profit in just a short time.

[ticks 10]

Profit is climbing but i still stay in the trade. Check out the Delta shown just below the graph...

[steve46 12]

"On average you will need to capture more than the $1 a day. (Due to the slope/rate of decay changing this will be likely only $.3 a day early on, and $3 a day later on -- More detailed Greek analysis is required - beyond any scope here and individuals can read this themselves)

However the point being..... every day the underlying might move up and down around the strike but still close there every day at the strike.

Historical volatility might be zero

Actual captured volatility might be $.50

Implied - irrelevant as you have already purchased, unless you wish to then sell out the options again, and then this becomes a trading spread cost and you have in fact traded volatility as opposed to trading gamma."

 

Couple of things here....first you folks were doing such a good job of describing this up to this point.....then......boom

 

First, "decay" happens at an irregular rate.....in fact the relationship of decay to price is NOT linear....instead of looking at a simple chart like Ticks shows....try looking at a vol surface....what you will see is called "bucketing".....suddenly you are up or down significantly more than you expected....

 

Second...what you accomplish during the trading day is your realized profit for that day...in the overnight market, a news event can cause problems as your target market gaps up or down...causing your delta's to change (without you having the ability to hedge).....NOW what....do you exit....if you unwind that position, then the implied vol IS important....you mention "black swan" events....this is the reality of that phenomena

 

Now one might think from this comment that I am a "naysayer"....I don't see it that way....for example, I remember very clearly holding 200 doubleclick puts and having my clerk tell me that there was "nothing done" when I tried to unwind.....(for the newbies that means "no one willing to buy").......what I am suggesting is that the authors take the time to describe the downside risks a bit more accurately...

 

Thanks

 

Steve

[SIUYA 11]

Steve, welcome along - you always do so well until you open your mouth then boom.

Please feel free to contribute without the need to go boom.

 

You of all people might understand that these are simplistic examples and that its pointed out that people need to do further reading or ask questions.... Tics may want to imply it is simple, Tics makes the point often its overly complicated but I respectfully disagree with him and if you did not get that from my writing then let me be loud and clear -- This is not without risks ---- .....so no need for your normal condescension thanks.

Tics might prove us all wrong.

 

 

"On average you will need to capture more than the $1 a day. (Due to the slope/rate of decay changing this will be likely only $.3 a day early on, and $3 a day later on -- More detailed Greek analysis is required - beyond any scope here and individuals can read this themselves)

However the point being..... every day the underlying might move up and down around the strike but still close there every day at the strike.

Historical volatility might be zero

Actual captured volatility might be $.50

Implied - irrelevant as you have already purchased, unless you wish to then sell out the options again, and then this becomes a trading spread cost and you have in fact traded volatility as opposed to trading gamma."

 

Couple of things here....first you folks were doing such a good job of describing this up to this point.....then......boom

 

First, "decay" happens at an irregular rate.....in fact the relationship of decay to price is NOT linear....instead of looking at a simple chart like Ticks shows....try looking at a vol surface....what you will see is called "bucketing".....suddenly you are up or down significantly more than you expected....

 

 

............

As to your kindly pointing out TD is not linear - thanks - I never implied it was and in the example clearly states the word average, and that it changes over time. Period. It is currently beyond the scope of this thread and not the point being made - as stated.

 

...............

 

Tics has shown what looks to be a payoff diagram - this is totally different to a volatility surface. So when you say "suddenly you are up or down significantly more than you expected...." "bucketing" -

could you please explain to everyone what you mean by this - in relation to a payoff diagram and a vol surface, as that is the first time I have every heard of that expression?

 

..............

 

Second...what you accomplish during the trading day is your realized profit for that day...in the overnight market, a news event can cause problems as your target market gaps up or down...causing your delta's to change (without you having the ability to hedge).....NOW what....do you exit....if you unwind that position, then the implied vol IS important....you mention "black swan" events....this is the reality of that phenomena

 

Now one might think from this comment that I am a "naysayer"....I don't see it that way....for example, I remember very clearly holding 200 doubleclick puts and having my clerk tell me that there was "nothing done" when I tried to unwind.....(for the newbies that means "no one willing to buy").......what I am suggesting is that the authors take the time to describe the downside risks a bit more accurately...

 

Thanks

 

Steve

 

Second....ahem for those that missed the first bus - gaps and large moves overnight if holding a position is exactly what you want when trading like this.....long volatility gamma trading.

If you hold one strike and trade the gamma around it then once you have purchased it then implied vol after that is irrelevant. If you are rolling to different strikes then the volatility curve and considerations come into it, but mainly as a result of ITM, ATM, OTM skew and concentration of supply and demand at certain strikes.....as often most implied vol is fairly flat for simple rolls....but why roll all the time and cross the spread?

 

If you choose to trade in an out the spread and costs will likely kill you, and I dont advise it.

If you get stuck with a position because you wanted to unwind something on the close and no one was there to take the opposite side, you can always hedge and hope for a gap.(Remember these markets generally have most of the liquidity provided by market making firms....and if you are leaving things to the last minute - why would you expect them to be there?)

 

I probably used to be on the other side of such trades as this and have seen plenty of people expect the market to be there when it suits them.....for those newbies out there its called liquidity and its amazing how many more seasoned investors often forget its importance.

Here is few a stories of liquidity --- all beyond the scope and off topic of this thread

• Try and sell the average daily turnover of a stock with 15 mins till close - likely to cause problems on the day before it goes ex-dividend.
  
• Try and unwind a position with PIN risk - when an instrument closes on expiry day right on the strike and you have to guess which options will and will not be exercised when having physical delivery and you have positions totaling 10 times 200 contracts, and everyone int he pit is in the same boat.
  
• Try and manage a book when you have massive skews across months and strikes where you are desperate for a crash but screwed if there is a takeover
  

Most people will be too small for this to be a problem and Tics pointed out it should work in liquid tight markets - the major downside being that you will not make money if the vol is accurately priced.

..................

.....................

Steve - I dont think you are a naysayer but please read what is read without one eye closed and your normal condescension and let the thread develop and please feel free to point out the risks with examples. Thanks.

[bobcollett 10]

Most traders will find this discussion and information rather complex.

 

Please understand that one need not know how an automobile engine provides the power to drive the car. So you don't have to be a full-on auto mechanic or engineer to press the accelerator and steer the car.

 

This is really a simple trade to understand and "drive". The danger is to get too caught up in the details. If there really is enough interest here to delve into to this profitable strategy then we can perhaps get to the "nitty-gritty" of how simple this is.

 

My concern is how few participate. On the TL start page it shows 85,000 plus members but where are they? No one seems to post except for a few "regulars". The reason I point this out is that it takes time and effort for those who post and it seems rather fruitless to put out information here.

 

Hi Ticks

You got it wrong. :doh:

I made the same mistake,giving my views and not receiving feedback.

And then wondering if my posts are just plain stupid. (OK dont say it )

84 800 members come to TL looking for help... how to stop losing money.

They dont know enough to reply.................

If my uncle Albert asked you for comment on his latest equation, how would you answer?

Another 100 mebers come to TL with some knowledge. Most dont go past 8 posts in 6 years, because they dont really need the criticism.

Another 98 make some contribution and good comment

And Patuca and I come to chat.:rofl:

So there you have it.

kind regards

bobc

OOPS I forgot about the vendors

[ticks 10]

CLARIFICATION may be necessary at this time due to PM's I recently received regarding my posts on this thread:

 

1. Some think I am selling something and they are waiting to see when that happens.I have been a member of TL since 2007. I usually never post and seldom even read the forums. I have nothing to sell. I don't need anyone's money and if I were selling most could not afford what I would charge for my work. I can easily live without the need to post. So perhaps it is time to go back in my trading cave and forget about this thread.

 

2. The so-called variation of the gamma scalp that I use does not greatly suffer from time decay. Why? Because I am only in the trade for about an hour before adjusting. No long holding times -- not much exposure to time decay loss.

 

3. All the Greek components are included in the risk graph I posted. So the greels and the total understanding of them is unnecessary.

 

4. I have benefited from this posting experience. It demonstrates to me the level of understanding that the readers on this board have trading in general and options in particular. Credentials, past experiences, war stories and bragging rights seem to be the central focus. The number of posts seem to also be important on this and I guess on other boards. For me making money is my focus. This starting to distract from that focus. I also learned that most readers are not here to learn.

 

5. I therefore respectfully will no longer post here but since I started posting on this thread -- I will answer any serious questions by PM.

 

6. Thanks to all for the experience I gained from this posting effort.

[ticks 10]

Hi Ticks

You got it wrong. :doh:

I made the same mistake,giving my views and not receiving feedback.

And then wondering if my posts are just plain stupid. (OK dont say it )

84 800 members come to TL looking for help... how to stop losing money.

They dont know enough to reply.................

If my uncle Albert asked you for comment on his latest equation, how would you answer?

Another 100 mebers come to TL with some knowledge. Most dont go past 8 posts in 6 years, because they dont really need the criticism.

Another 98 make some contribution and good comment

And Patuca and I come to chat.:rofl:

So there you have it.

kind regards

bobc

OOPS I forgot about the vendors

 

 

Bob I just saw your post and it deserves a thanks to you before I leave the post. Your explanation makes sense.

[SIUYA 11]

Ticks....

the reason why people think you might be selling something is many who do sell there ideas often do/say much the same thing - " i dont have the time, " but then -- "PM me", "Call me". This "strategy is simple", "its new", "its unique"

Often the result of unintended consequences.

Many here post because they like to help or as Bob says like to chat. Some just read.

Dont get offended by it. If you have something to offer or sell, be up front about it no one cares unless it seems to be hidden, if you dont and want to help then help others with posts. Some are simply promoting products which is fine also.

There are plenty who trade and have separate blogs etc. This is just a different forum....polite dissension is good IMHO.

As for war stories and supposed credentials - you would rather learn from people who have not been there done that?

 

As for your trading style I know it works, but as I and Steve (in his own manner) rightly points out there are risks. If you deny this then you are living in denial.

 

As for your previous two screen shots - what are the prices and the resulting PL after unwinding the trades after costs as I could not see any bid asks in either the options or the underlying apart from maybe your initial trade prices? (Some systems dont show the whole story)

 

I hope you dont go

[steve46 12]

Alright then....first, the concept (gamma scalp) is not complex and it is a good subject to explore....as long as the explanation is offered in a simple down to earth fashion....Siuya is doing a good job of that (in my humble opinion)....and ticks....the idea he offers is fine, the problem I may have with some of this is that there are a few "issues" that a trader needs to understand in order to participate.....I like to see a balance struck if possible...

 

As for using a vol surface...that's my mistake....its going to be too complex a tool for folks to use in this context....my apologies....for anyone interested in researching that subject further, here is citation that can serve as a starting point.....

 

http://www.columbia.edu/~mh2078/BlackScholesCtsTime.pdf

 

I am glad to stand aside and read the rest of the thread as it develops

 

Best of luck to all

 

Steve

[SIUYA 11]

 

I am glad to stand aside and read the rest of the thread as it develops

 

Best of luck to all

 

Steve

 

Steve please contribute you probably have examples that will help and provide points for debate/discussion - I just comment that your manner often distracts from your message.

Regards,

[SIUYA 11]

An important - crucial point to learn when trading using options.

 

Put call parity

 

As an option or any derivative is essentially just a way to transfer risk over time and price via choosing different strikes or months then you should always remember exactly what it is that you are creating synthetically when trading options.

 

There are more complicated ways of looking at (using discount rates etc) and those more mathematically minded should feel free to explore further - it but in keeping it simple

variations of this are often seen in many of the simple payoff diagrams.

 

Long Underlying = long call and a short put

 

I would suggest a great resource for this is the Khan accademy

https://www.khanacademy.org/science/core-finance/derivative-securities/put-call-options/v/put-call-parity-clarification

 

For those not mathematically minded to be mucking around in positives and negatives and long and shorts - which is one reason why I think a lot of people skip over this - keep it simple.

The point is that you need to understand is that when you have an option and you hedge it you are in fact creating a synthetic and creating a different set of exposures.

 

................

By thinking about options and their trading in terms of synthetics you will (I hope) avoid a lot of the pitfalls and traps of options because you are understanding what you are creating and not what risks you thinking you are eliminating.

 

.................

...................

................

The other crucial point when thinking about options and learning about them is to remember - the pay off diagrams that are normally drawn occur AT EXPIRY -- they dont necessary have the straight lines prior to expiry - this also confuses a lot of people.

The pay off lines move and converge towards the payoff at expiry diagrams over time.

So the important point to remember here is that delta, gamma, vega - the Greeks, also change over time.

eg; Day one the delta of an option may be .40. The next day (day 2) with no change in the underlying, the delta may be .39.

 

This change accelerates as expiry approaches.

Remember this simple point - at expiry time an option is either delta 1 or delta 0 prior to this the numbers will be different but they will converge towards this.

[SIUYA 11]

Time for a war story showing one of the risks based on the fact that the greeks converge ( from curved lines when plotted to straight lines) to the expiry payoffs.

 

(I hope to explain these simple examples in words, and any one with a demo/simulated options valuation model can test these themselves.)

.................

 

Lets say :

underlying is 90, days to expiry 6, Call strike is 100, call delta today (Day-6) is 0.30

Lets assume you are wanting to keep a delta neutral position. you are trading the gamma when you can, and so in this example you might be long 10 calls, and short 3 underlying.

 

Think about this scenario....

Day-5 underlying price 92 - Delta 0.30

day-4 underlying price 94 - Delta 0.30

day-3 underlying price 96 - Delta 0.28

day-2 underlying price 98 - Delta 0.25

day-1 underlying price 99 - Delta 0.20

Day-0 (Expiry) underlying price 100 - Delta 0

 

How does this happen? Delta is meant to go up as the underlying rises!

As the option nears expiry the delta tends towards zero as it is out of the money.

If you have hedged on Day-6 and sold 3 contracts in the underlying you will have to buy these back either as the underlying price rises, or on the expiry day....ouch.

 

The reason is the convergence of the delta toward is zero is greater than the change in delta due to the price rises.....

 

You must keep an eye on this as options approach expiry. The easy way to do this is scenario test constantly by moving prices and days till expiry - understand how the derivatives act.

Now some will say they will just roll or unwind before expiry.....they will often miss great opportunities! (time for another post)

 

 

..............

The war story....

This happened in an equity stock and a few traders had similar positions because of supply and demand and we were all in the same boat, a large OTM call position.....we were all standing around bitching and moaning how the stock was not being volatile and time decay was killing us and how some of them had to be square (flat) deltas....so they were hedging every night trying to keep this, and there was no real buyers of options for them to be able to off load their position.

I was in the habit of scenario testing and moving dates forward and realised that we were actually getting shorter while the stock was slowly rising. As it was in an uptrend i was leaning on my deltas and staying slightly long - however the reality was it was just keeping the position fairly flat. It saved me a lot of money, whereas some others had to purchase their shorts back, because they were in fact purchasing puts in a rising market with their hedges. (In Australia at the time each option contract was for 1000 shares per contract not like the USA where it was 100 - there was a little more leeway to get it wrong)

 

Note: this did not make me money, in fact the whole situation cost as the time decay killed us, but it saved me money. For me the trade off was this - if the stock fell, then I would not have been in a position to make anything from my short underlying (not a problem as we had other strikes that were ITM) but as the stock was rising, I either saved money by 'underhedging' or made a lot more if the stock really rallied well past the strike as i was not as short. --- a good trade off as far as I was concerned.

 

BUT it just goes to show you have to constantly keep an eye on the real exposures.

 

...............

Note to some - if you dont like stories - treat them as such - educational stories -I dont mind if you choose to think they are worthless - prove me wrong with your own stories - these are simple examples of what I had seen or have happened to me mainly over 12 years of options trading alongside others, in the hope others might learn should they adopt this style of trading.

Edited August 1, 2013 by SIUYA

[bobcollett 10]

Hi SIUYA

You certainly know your stuff

Educational, well written, and entertaining.

Can you please comment on COSTS.

They obviously differ from country to country

regards

bobc

[SIUYA 11]

hi Bob, glad you like it. I usually think its a bit off the cuff which misses the point sometimes (especially if hung over or arguing with the dog and kicking the wife) )

 

The thing to remember about my experiences is that i was a market maker. we had certain advantages in the old days but these days while it is different the basics are the same and its often now better to be a price taker once you have reasons for purchasing options, and a reasonable method for re-hedging...

 

Which is ultimately the key for costs. the more you hedge the more the costs, but if you are very diligent the rehedging is only when you have a delta to rehedge - or if you have a method for buying at support, selling resistance etc; you can lean against the deltas a bit, and the costs become minimal. If you like to over trade this style wont help as it is more likely to exacerbate the problems. (and trust me - some people feel they need to lean against the deltas all the time - sitting on your hands is still a virtue - but the default becomes "if you dont have a view, but you have a delta - hedge"

 

...................war story flashback with wavvvvy fade in fade out.....

Asked by a fellow trader what I thought if the chart on a particular stock as he knew i charted (pencil and paper old school during the day sometimes) I replied - " I have no idea"

15 mins later someone sold me some cheap calls and immediately I thought to myself - they were cheap, I have a long position, therefore I must be bullish.....:doh: - ----luckily the 30secs of clarity (the type you get at the end of a night whereby you either go home or you get into trouble) kicked in.

I hedged and figured if i did not have any idea, the call seller might - qick reassessment, I over hedged, (leant on the deltas) and went short.....the stock went down (which is why the story always sticks in my mind)

 

 

..................fade out wavvy fade out, back to reality.

 

We ended up averaging less than 20% in costs per $1 made (initially there was a group of 8 then 3 independents back in 1993-2005)......this included all clearing costs as market makers and when doing this independently (as opposed to being at a broker where often you were charged virtually nothing) we were paying 2-3 basis points for the underlying and all in about $1.5 for options. Financing was about 50 bass point above official rate and 75 bp below for shorts, and we negotiated hard - the biggest fixed cost at the time was the trading system and data feeds etc........It was not a major factor but still could make the difference between a small win, loss or break even month and we were tight as we wanted the money in our pocket. (these days its all automation to do properly and big bucks to set up)

 

As a retail guy, you get a pretty good deal from a good discount broker, and the key will still be in when you hedge and the rationale for buying the options in the first place.

Costs these days are good, and it clearly makes a difference in which country you are in. Additionally - we had big option books which meant volume kept costs down relatively, we met any minimums the broker might want to charge (seems the norm these days for some clearers). Small guys have patience and no requirement to buy volatility or make markets - this is to their advantage.

 

The biggest cost is in time - keeping option positions like this means you never know when a big move will occur, and also the focus required for capturing the extra volatility you require to profit from more than the implied vol you paid. Miss the move for the day and you just have time decay, and yet hedge to early and miss the big move - worse still!

(One reason why i dont do this anymore, but if I wanted real focus again I would - luckily the market for this has been crap of late due to declining vols and crap markets)

 

On looking back at old PLs (they are in a shed in a box back in Oz) it is a good reminder that often you spend weeks chipping away for nothing simply covering costs, to then have a series of big wins. (This is the real value in this type of trading)

..................

I will try and keep just pumping out some examples of what to look out for when they come to mind - maybe a few feel good trades.

Edited August 1, 2013 by SIUYA

[SIUYA 11]

A feel good trade.

 

Trading gamma does have its risks...it also has some potentially big rewards.

This in my opinion is the key to success - real success when trading long volatility.

 

This in my parlance is the ability to end up with 'free options'. "Froptions"

 

.......................

What is a free option

It is an option that effectively has no time decay (or a very small amount left on it) because either the underlying has moved far enough away from the strike, but it still has time till expiry.

 

These can be OTM - because the underlying has moved away from the strike and there is nothing to hedge

These can be ITM and the deltas are fully hedged, effectively giving you the synthetic option (ie; a call at delta 1 (ITM) that is hedged with a short underlying = OTM put at the same strike)

 

How do you make your money out of these?

 

Ideally, you would have already covered the cost of them - by trading the gamma, or if not you were not too badly hurt. The money is made when there is a big move - the black swan event - or even if there is enough time, a trend starts to occur, and you are able to let the options run.

 

How much time until expiry is good?

 

Obviously the more the better, but it does not matter - big moves can occur any time, even on the day of an expiry.

 

Whats the key to it?

 

Simple - dont sell them out if you get them..... and if something starts running your way, the default in this case is not to hedge. The reason is it cost you nothing, and if you are not careful your rehedging may in fact cost you again. However - dont look a gift horse in the mouth and at some stage the freebee profit should be taken.

 

Why this is hard to do?

 

Like most things in trading the temptation to take profits, or in this case to sell something for a few cents that is theoretically worth nothing is high. Too often traders sell their free options out too cheaply, and in doing so they miss the opportunity to make big money. (Now people will argue that you are better off taking profits, etc etc.....but I am talking about opportunity cost v taking a few cents here and there, especially when you have a position that will cost you nothing to hold)

 

There is a margin cost to holding these. You will have to fund the position if it is long puts, long stock or even if its long calls, short stock. (which is why having OTM options for free is a nicer result) However, this margin cost is small, offsets from portfolio margining through a good broker should be had, and again it really helps to have a larger account than many retail traders have.

 

......................

War story fade in and out.....

I have attached two examples - they are a presentation I did with some others to show examples of such trading. These were actual trades and entry levels. We also showed example of where we hedged too early, and even some examples whereby we got it wrong and this cost us money - the first example is hedged early as it was on expiry day and rolling the options in this case was deemed too expensive......but the point is this is where we made good money trading this way. (these are stocks in Australia)

The first example is a true free option when fully hedged, the second shows how we actually got the direction wrong and were long deltas coming into the move, but how the resulting long volatility and change in deltas from the gamma ended giving us a short position with the big gap down and we made money (in this case it was a very good day as the position was quite large - I do remember reading the news and cursing and swearing that we were on the wrong side, and that it would probably only fall enough to cost us money and then not much more....its good to be wrong sometimes!)