Options: Gamma Risk Visualized

Many neophyte options traders become unsuspecting victims of gamma’s wily ways. While these profit seekers are well-intentioned, their ignorance can prove costly, particularly close to expiration. Let’s just say the last few weeks leading up to expiration are when gamma really takes hold and begins to play with your position for better or worse.  Here are four key facts on gamma:

1. Gamma is the rate of change of delta.

2. Gamma is the curvature of an option.

3. Gamma is highest for short-term ATM options.

4. Long options have positive gamma, short options have negative gamma.

The second definition speaks to the general shape of an option’s risk graph. Low-gamma positions possess a flatter risk graph, reflecting greater stability in the position. High-gamma positions boast a risk graph with significantly more curvature, reflecting heightened instability in the position.

Take the risk graph of the butterfly, included below, for example. The butterfly is a delta-neutral, negative-gamma position engineered to profit from either the passage of time or a decline in implied volatility. When structured with longer-dated options, the position is quite stable, with losses accumulating slowly during adverse conditions.

Take note of the relative flatness of the blue line, which illustrates the lower-gamma risk when the position is 38 days to expiration. Contrast this with the red line, which reflects the same position three days from expiration.

Gamma has grown and is now a dominant force influencing the outcome of the trade. The position is increasingly unstable, as revealed by the excessive “curviness” of the risk graph. Given the steepness of the graph, even a small move in the wrong direction will result in giving back significant portions of the profit.
Click to Enlarge

[Source:  MachTrader]

Managing a negative gamma position of this sort close to expiration can be a nerve-wracking high-wire act.  While successfully traversing the wire promises outsized rewards, a slight misstep in either direction will prove quite painful. Of course, one can sidestep the tightrope altogether by exiting positions once gamma grows larger than one’s risk appetite.

Keep this in mind the next time you’re playing with negative-gamma , such as short puts, credit spreads, condors and butterflies. To avoid the excessive gamma risk, consider closing them before getting too close to expiration.

Article printed from InvestorPlace Media, https://investorplace.com/2012/05/options-gamma-risk-visualized/.

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