Options Trading: Key to Having the Right Leverage Is Having the Right Gamma
By Steve Smith Aug 09, 2011 1:45 pm
Options are leveraged products, which means big profits but also bone-crushing losses. One way to have the right kind of leverage is to have the right gamma on.
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To say the recent market volatility is inhuman would be an obvious understatement. And for option traders it shouldn’t necessarily be viewed as a bad thing. In fact, if positioned correctly, this action represents massive opportunity. Like a surfer seeing swells mounting and a distant storm, one could sense a few weeks ago that things were getting gnarly in this market. Likewise, a game plan is need. Safety first, always. Maneuverability -- that means scaling down position size and only trading in liquid contracts. And believe it or not, leverage; being positioned to benefit from the powerful thrusts of strong directional moves.
The first two are easily addressable: 1) simply reduce your usual position size by a 1/3 or half, 2) with correlation -- or the tendency for most stocks to move in unison -- focus on trading index funds such as Spyder Trust (SPY). Rather than trying to pick an exact entry point on an individual dinghy of a name, use the battleship of ETFs to navigate swells. It may not be as exciting, but it will most likely be less heart-wrenching.
The tougher nut is how to get leverage on your side without adding exposure. Options are leveraged products (stemming from low margin requirement to control 100x number of shares per contract) but this leverage can cut both ways, big profits but also bone-crushing losses. One of the keys to having the “right” kind of leverage is having the right (in this case positive) gamma on.
Gamma is a second derivative and measures how much your delta will change per unit change in price. It means that as prices rise, your delta increases. Or more pertinently, as prices decline your delta turns more negative, meaning you get longer as prices go up, and shorter as prices decline. Sometimes people confuse gamma with vega, which is a measure of volatility. They sometimes act in concert but are not related. Getting long gamma usually comes in the form of owning or being net long more options contracts then one is short. This can be for both puts and calls, individual positions or a broader portfolio. As a generic example, the OptionSmith portfolio had a pretty positive delta three weeks ago (maybe approaching 25 one of the highest on record) as I was long a dozen or so individual names ranging from Akamai (AKAM) to Riverbed (RVBD) to Bunge (BG) to Spyder Industrial (XLI). I was getting a daily whacking. But thanks to using the SPY to set up bearish put positions -- mostly back spreads in which you sell or short x number of puts and then buy or go long 3x-5x number of put contracts -- I had essentially created a portfolio that resembled a married put with the kicker of being long gamma on the downside. What does all that mean? The losses in the individual names, which mostly occurred last week, have now been more than offset by gains in the SPY gamma boy protection program.
Being long gamma also provides flexibility. If one is short gamma (net short options and hence volatility), one usually has to take a defensive stance when one large move occurs. By contrast, being long gamma allows you to react and respond. Over the past few days, most of my trades have been adjustments, such as lifting off all SPY put protection and pivoting into various call spreads and also adding some new individual longs. These are mostly covered or even ratio spreads, which means my gamma shield has been lowered for the moment. I’m doing this because I want to take advantage of the spike in implied volatility, but as soon as IV dips back down, my net longs will become strung out across the positions universe.
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