Full index of posts »
StockTalks

The Bursting Of The "Bond Bubble" $BND, $AGG, $LQD http://seekingalpha.com/p/1p9q7 Apr 23, 2014

Dexia May Be Left as 'Bad Bank' as Governments Avoid Injections Oct 5, 2011

Seems that the dollar has topped out for now. Looking to get long AUD May 19, 2010
Latest Comments
 Surly Trader on Risk Flare Ignited I agree with you about putting things into pers...
 Nitin Gulati on Risk Flare Ignited But we should also put into perspective that 1....
 Nitin Gulati on VIX – Tale Of Two Tails I completely agree with your analysis, some thi...
 KidPlunger on Scalping Gamma Great article,Two questions, and I'm sorry if t...
 Mistrofan on Trading the VIX/Futures Gap Don't go long on VXX  you will burn your fingers.
 Surly Trader on Option Skew as a Trading Signal Written puts on the S&P 500 with a short po...
Most Commented
 Dubai  A Crisis of Confidence ( Comments)
 Option Skew as a Trading Signal ( Comments)
 Risk Flare Ignited ( Comments)
 Scalping Gamma ( Comments)
 Trading the VIX/Futures Gap ( Comments)
Scalping Gamma 1 comment
In my last article on option trading I suggested that longer term implied volatility looked rich while short term volatility looked cheap. The strategy that I suggested to extract this value was to buy shortterm ATM puts, sell 1 year or greater out of the money puts, and delta hedge the position. I called this getting “Long Gamma and Short Vega”. There were many comments related to simpler strategies on the VIX or via variance swaps for the lucky Europeans who have them to trade, but I maintained that I believe the strategies can be very different because of the flexibility and specificity that options provide.
When discussing how to mitigate gamma losses, I used Yahoo as an example, but this time I will explore the S&P 500 because it looks even more ripe for this trade idea. The first thing we need to examine is the option implied volatility skew:
There are two things that you should notice about these curves. The first is that 1 year implied volatility is trading at higher levels than 1 month implied volatility. The second point is that the curves exhibit “reverse skew”, which simply means that the lower strike prices trade at higher implied volatilities than at the higher strike prices. This gives us two takeaways: 1) If we are selling options we would prefer to sell longer dated options (higher implied volatility) 2) when we are buying options we would prefer to buy them at higher strike prices (lower implied volatility).
With these two things in mind comes the strategy that I originally suggested: Long Gamma, Short Vega.
Now that we have the strategy down, let us dissect why it makes sense. From my previous post on mitigating gamma losses, we know that options exhibit large gamma at the money close to expiration. Let us consider a purchased put option on the S&P 500 with a strike price of $1,150:
Gamma spikes dramatically when options are close to expiration and the underlying trades near the strike
Gamma is what whacks option sellers silly because a written option with a small loss can turn into a very large loss when the option nears expiration and the underlying spikes into the money. In the case of being long gamma, we are happy to see the underlying move rapidly because that means that there is more of a chance that our long option position will end up far in the money. If we are long an option and gamma scalping, we are also happy to see the underlying move quickly because we lock in large gains. This can best be understood with an image:
Because of a positive gamma, the deltahedged long put option gains in up and down scenarios
Profit & Loss from a DeltaHedged Long Put position rebalanced at the 1,100 S&P 500 level
The important piece to keep in mind when examining the P&L of the deltahedged position is to remember that you rebalance, or hedge your delta to zero, at discrete points in time. In this example, we assume that you rehedge when the S&P 500 is at 1,100. The profit of $13 occurs when the S&P 500 falls to 1,000 before you rebalance your hedged position. Likewise, the profit of $15 occurs when the S&P 500 rises to 1,200 before you rehedge your position. This is just an illustrative example, but it shows that the option gains more when the market falls than the long stock position loses. This happens because the option’s delta gets closer to negative one as the option moves further in the money while your delta hedge position remains constant at 65% of the option notional. In this position, we crave realized volatility for the profitability of the deltahedged long option strategy.
If we pair a long position in the ATM shortterm option, which has a very high gamma, with a short position in an out of the money longdated option then we still end up with a net positive gamma. This position will only flipflop to a negative gamma when the market moves towards the out of the money written strike. Therefore, we can scalp gamma in the shortrun while having an overall short vega position on longerdated written option. I will let this idea sink in and leave short vega positions for another time.
Disclosure: Short SPY Vega
Disclosure: Short SPY
Instablogs are blogs which are instantly set up and networked within the Seeking Alpha community. Instablog posts are not selected, edited or screened by Seeking Alpha editors, in contrast to contributors' articles.
Share this Instablog with a colleague
Two questions, and I'm sorry if they are dumb. 1. So I kind of get your rationale for for examining the right security for a delta hedge with a relative value proposition where long term vol is rich and short term is cheep.
2. Could you give a bit more color as to your methodology for the discrete hedging, also I assume you are not holding these options to maturity, but at the same time the gamma is the highest near expiry, could you elaborate on the tenors you are using and how you manage your theta bill.
Thank you.