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Understanding Gamma Risks With Iron Condors

When new options traders move beyond directional options strategies and begin to explore neutral approaches, iron condors are an early stop on that voyage. Traders discover that they can make money by being long the very thing that caused their directional strategies to lose money - theta. And selling time decay seems brilliant.

With it they realize that they are also short vega. While this can provide them with juicy premiums (particularly on the put side of the trade), they also learn that a strong move down in the underlying will result in a significant pop in the implied volatility, wiping out the orderly theta decay that they had been enjoying.

Once the market stabilizes, implied vol drops back down and the positive power of theta decay resumes its march towards expiration. Assuming short strikes remain safely out of the money, the trade becomes comfortable again. So comfortable that it encourages these new iron condor traders to stay in their positions. In fact, why not just ride it out right through expiration and collect the remaining credit and avoid the commission that comes with closing a multi-leg spread?

Gamma Risk

Gamma measures the amount of change in an option's delta when the price of the underlying moves. As you can see from the chart below, gamma is highest for at the money options and gradually trails off as the options move further in or out of the money. Higher gamma means a trader's options have a greater sensitivity to changes in the underlying.

Iron condor traders are short gamma since their short strikes have a higher gamma value than their long strike hedges. Any options position that is positive theta (profiting from theta decay) is short gamma.

For example, with the RUT at 960, the 960 call will have the highest gamma value of the surrounding call strikes. A move up to 970 in the RUT will increase the delta of the 960 strike by a much greater percentage than the delta of a strike that is already deep in the money or far out of the money.

The above chart shows the gamma values for the RUT weeklies (white, 3 days until expiration), RUT front month(yellow, 23 days) and the RUT back month (red, 50 days).

Normally, an iron condor weathers movement in the underlying (within reason) due to the offsetting behavior of the spreads. As the underlying moves toward the short strike, the gamma of that short strike climbs, as does the delta. This can cause the (unrealized) loss on the short strike to mount, although it is partially offset by the long strike that makes up the spread.

Iron condor traders run into issues when this scenario occurs in the last two weeks before expiration. The most dramatic aspect of the gamma chart is not the ATM vs ITM/OTM difference but the spike in gamma as we approach expiration. The value of the short strike in jeopardy climbs rapidly. The steep pitch of the gamma curve highlights the differences between ATM and other strikes.

With so little time remaining until expiration, the long strike does not provide any help offsetting the spike in the short strike price since it is further out of the money. The options market participants simply doesn't think that the long strike is likely to end up in the money in the limited time until expiration (hence the steep pitch in the gamma curve). The new iron condor trader, who felt so comfortable in the fully hedged trade, now has to take a loss that will take several months (or more) to recover from. All because he/she wanted to squeeze the remaining credit from an iron condor.