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Gamma Scalping vs. Bleeding
introduction
As option theory hinges on volatility, the most basic decision for an investor involves his/her expectations with regards to the volatility of the market. An investor's view on the expected volatility will decide whether the person in question will be a seller or a buyer in the market. As we will cover below, a long position in standard options - and thus in gamma - basically means that swings in the underlying asset are beneficial to the investor due to gamma scalping. The flip side, however, is that a long position is costly in stable markets where the option bleeds the speculator.
Gamma Scalping
The gain from a long position in gamma stems from the 'gamma scalping' that occurs when the market is moving. If an investor believes that the volatility of, for instance, the EUR/USD is 'too cheap' - i.e. he/she believes that the actual volatility is above what is priced in the market - the investor can profit from this by taking on an option position and hedging it in the spot market. As mentioned above, all vanilla options have long gamma positions implying that the delta of the option increases when the underlying asset increases and vice versa. If an investor is long in an option position and has hedged this position in the underlying asset, he/she will acquire a long delta position when the spot increases (regardless of whether it is a long Put or Call position because the Delta of an option will increase for all purchased options). To remain delta neutral, the investor will sell an amount of the underlying asset. Conversely, when the spot decreases the investor buys the spot. Hence, as the position in the spot changes the investor will always be buying low and selling high. This concept is known as 'gamma scalping'.
The Cost
Unfortunately, as basic economic theory tells us, there are no free lunches and the investor will pay for buying low and selling high through the premium of the option. Hopefully, from the investor's point of view, the swings in the spot and the subsequent gamma scalping gains will outweigh the premium paid for the option. The risk for the investor of such a strategy is that the market remains dormant. When this occurs, the option is bleeding the investor since the reduction in the time to expiration reduces the value of the option. This cost is commonly referred to as the theta of the option.
Example - Long Call/Short Spot
If you buy a 30 Delta EUR/USD Call for one million with a gamma of 5% you can hedge the option position by selling 300.000 in the spot. Now, if the spot increases by one percent, the option becomes a 35 Delta Call. Since you are long in the option you will now have to sell an additional 50.000 in the spot market to remain delta neutral. If the spot then falls back to its previous position the option once again becomes a 30 Delta Call and you will buy back the 50.000 to remain delta neutral. However, the selling price was one percent higher than the purchasing price implying that you have earned one percent on the 50.000 (or 500 euro), even though the spot is at its original position. These gains are due to your long position in gamma and are known as 'gamma scalping'. Hence, if the actual volatility turns out to exceed what was priced in the option the 'gamma scalps' will add up to exceed the premium of the option. The buying low and selling high strategy also comes into play if the spot decreases.
Example - Long Put/Long Spot
If you buy a 40 Delta EUR/USD Put for one million with a gamma of 5.8% you can hedge the option position by buying 400,000 in the spot market. (The delta of the Put is actually -40 since the Delta of a long position in a Put is negative. However, market convention is to omit the negative sign.) If the spot, like before, increases by one percent the option becomes a 34.2 Delta Put (-40 + 5.8 = -34.2). Since you have a long position in the spot of 400,000 this implies that you become long in Delta and must sell 58,000 of your position in the spot to remain Delta neutral. Similarly, if the spot descends to its original position you will have to buy back the 58,000 that you just sold. Like before, you are buying low and selling high.
Gamma Scalping vs. Bleeding
introduction
As option theory hinges on volatility, the most basic decision for an investor involves his/her expectations with regards to the volatility of the market. An investor's view on the expected volatility will decide whether the person in question will be a seller or a buyer in the market. As we will cover below, a long position in standard options - and thus in gamma - basically means that swings in the underlying asset are beneficial to the investor due to gamma scalping. The flip side, however, is that a long position is costly in stable markets where the option bleeds the speculator.
Gamma Scalping
The gain from a long position in gamma stems from the 'gamma scalping' that occurs when the market is moving. If an investor believes that the volatility of, for instance, the EUR/USD is 'too cheap' - i.e. he/she believes that the actual volatility is above what is priced in the market - the investor can profit from this by taking on an option position and hedging it in the spot market. As mentioned above, all vanilla options have long gamma positions implying that the delta of the option increases when the underlying asset increases and vice versa. If an investor is long in an option position and has hedged this position in the underlying asset, he/she will acquire a long delta position when the spot increases (regardless of whether it is a long Put or Call position because the Delta of an option will increase for all purchased options). To remain delta neutral, the investor will sell an amount of the underlying asset. Conversely, when the spot decreases the investor buys the spot. Hence, as the position in the spot changes the investor will always be buying low and selling high. This concept is known as 'gamma scalping'.
The Cost
Unfortunately, as basic economic theory tells us, there are no free lunches and the investor will pay for buying low and selling high through the premium of the option. Hopefully, from the investor's point of view, the swings in the spot and the subsequent gamma scalping gains will outweigh the premium paid for the option. The risk for the investor of such a strategy is that the market remains dormant. When this occurs, the option is bleeding the investor since the reduction in the time to expiration reduces the value of the option. This cost is commonly referred to as the theta of the option.
Example - Long Call/Short Spot
If you buy a 30 Delta EUR/USD Call for one million with a gamma of 5% you can hedge the option position by selling 300.000 in the spot. Now, if the spot increases by one percent, the option becomes a 35 Delta Call. Since you are long in the option you will now have to sell an additional 50.000 in the spot market to remain delta neutral. If the spot then falls back to its previous position the option once again becomes a 30 Delta Call and you will buy back the 50.000 to remain delta neutral. However, the selling price was one percent higher than the purchasing price implying that you have earned one percent on the 50.000 (or 500 euro), even though the spot is at its original position. These gains are due to your long position in gamma and are known as 'gamma scalping'. Hence, if the actual volatility turns out to exceed what was priced in the option the 'gamma scalps' will add up to exceed the premium of the option. The buying low and selling high strategy also comes into play if the spot decreases.
Example - Long Put/Long Spot
If you buy a 40 Delta EUR/USD Put for one million with a gamma of 5.8% you can hedge the option position by buying 400,000 in the spot market. (The delta of the Put is actually -40 since the Delta of a long position in a Put is negative. However, market convention is to omit the negative sign.) If the spot, like before, increases by one percent the option becomes a 34.2 Delta Put (-40 + 5.8 = -34.2). Since you have a long position in the spot of 400,000 this implies that you become long in Delta and must sell 58,000 of your position in the spot to remain Delta neutral. Similarly, if the spot descends to its original position you will have to buy back the 58,000 that you just sold. Like before, you are buying low and selling high.
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