ATTENTION OPTION STRATEGISTS : the following article is by Jeff Augen, options educator extraordinaire. This is short and sweet and well worth a few minutes to read. Good trading to all of you! Marko
OPTIONS TRADE: Trade Gamma as Expiration Approaches
By Jeff Augen
CONVENTIONAL WISDOM IS INCORRECT
Conventional wisdom suggests that short option positions designed to profit from time decay are most effective in the final days before expiration. The idea is that accelerating price collapse is likely to overwhelm any underlying price change. Traders often take advantage of these dynamics with short strangles, straddles or more complex multipart trades, such as condors.
Conversely, it is generally believed that long positions designed to profit from a significant price change of the underlying stock are most effective when expiration is a month or more away and time decay is slow. The slow rate of decay makes it reasonable to hold the trade open for an extended period of time waiting for a large price move.
Conventional wisdom is wrong. Option traders who try to capture time decay near expiration often lose large amounts of money because their trades are sensitive to small moves of the underlying stock. Long positions with distant expirations suffer the opposite fate—they are relatively insensitive to movements of the underlying stock but suffer from constant slow time decay.
These dynamics, which on first glance might seem counterintuitive, are related to gamma—the rate of change of delta.
GAMMA IS THE KEY
Delta represents the amount by which an option price will change if the underlying stock moves $1. Gamma represents the change that occurs in the delta. It is generally used as a measure of risk. Institutional traders track the gamma of individual positions as well as the overall portfolio. Being short large amounts of gamma is always dangerous.
The table tracks the results of a 2 standard deviation ($2.44) price change on the value of a delta-neutral strangle structured with $50 puts and $52.50 calls for a stock trading between the strike prices (implied volatility = 38 percent).
With only two days remaining before expiration, the price of the trade jumps from $0.31 to $1.34—a gain of 332 percent. An investor who purchased a 50 contract strangle for $1,550 would close the trade for $6,700.
At the bottom of the table, we see that the same trade placed with two months remaining would cost $25,450 and, after the price change, would be worth just $26,900—a gain of only 5.7 percent that might be impossible to capture with bid-ask spreads.
Gamma is the driving factor underneath the distortion. The two day out options have very high gamma on each side, – 0.19. With two months remaining, this value falls to .05. Stated differently, a $1 downward move of the stock near expiration will simultaneously lower the call delta and raise the put delta by 0.19 each. That’s a 0.38 change—an amount greater than the entire cost of the trade.
A METHOD FOR CAPITALIZING ON THE DISTORTION
As expiration approaches another important dynamic surfaces. Each day before the closing bell, the market tends to discount option prices to compensate for the large percentage of value lost to overnight time decay.
This change allows investors to efficiently structure long option positions to hold overnight in anticipation of a significant underlying price change when the market opens. During an active expiration week, a portfolio of such trades often delivers enormous profits.
Stocks with high implied volatility (greater than 40 percent) are the best candidates. Despite their inflated implied volatility, these stocks tend to exhibit a larger percentage of outsized spikes and a poor fit to the normal distribution upon which option prices are based.
Finally, many traders sell far out-of-the-money options near expiration to capture a few cents of premium. In a weak market characterized by rising volatility, that approach degenerates into a fool’s game that will not produce winning results for an extended period.
