Have you ever thought about whether or not it is possible to make consistent profits from a stock's volatility without having to guess where it's going to go next? Consider gamma scalping: a very advanced option trading strategy used by professional traders and market makers to profit from volatility in the markets without having to predict the direction of the price movement.
Gamma scalping is a market-neutral strategy that allows a trader to profit from short-term price changes by adjusting their position continuously in order to stay delta-neutral. Instead of trading on the directional movement of a stock, you are essentially betting on the fact that volatility will generate profits regardless of where the price ultimately moves.
Explore Our Courses in Stock Market Online
What is Gamma Scalping?
Gamma scalping is an advanced option strategy that involves establishing a position with positive gamma (or long gamma) and then continuously buying and selling the underlying stock or futures contracts to keep the delta of the total portfolio neutral.
With gamma scalping, the trader attempts to generate profits from the many frequent small price rallies of the underlying stock that will more than offset the constant decrease in value from theta decay, which is also known as time decay.
Understanding the Core Mechanics: Delta and Gamma
In order to fully understand gamma scalping and its inner workings, it is essential to first understand the relationship between two of the most important Greek letters: delta and gamma.
1. Delta: The Directional Measure
Delta represents how much an option price is expected to change for every $1 change in the underlying asset.
A long stock position of 100 shares has a Delta of +100.
If you purchase 10 Call options controlling 100 shares each with a Delta of 0.50, your total Delta will equal +500 (10 x 100 x 0.50).
The goal of the strategy is to build a delta-neutral portfolio - meaning the total Net Delta of your entire portfolio, including your options and stock/futures, has a total Net Delta of as close to zero as possible.
2. Gamma: The Volatility Engine
Gamma indicates the rate of change of an option's Delta as a result of an increase or decrease in the price of the underlying asset. It can be thought of as the "acceleration" of Delta.
For example, if the Delta of an option is 0.50 with a Gamma of 0.10 and the price of the stock increases by $1, then the Delta of this option would increase to 0.60 (0.50 + 0.10).
Many traders who participate in gamma scalping will try to maintain a long Gamma position (Positive Gamma), usually by owning Call or Put options. By doing so, they will benefit from price volatility.
Find Out Options Strategy Course
How Gamma Scalping Works?
The essence of this strategy lies in the continual process of hedging the delta in order to reap the profits gained from the price movement of the underlying asset.
The Step-by-Step Process:
Establishing a Long Gamma Position: To achieve Delta Neutrality, the first step a trader will take is to establish a Long Gamma position using a Straddle (Long Call and Long Put with the same expiration date) as an option strategy. Since the Call offsets the Put, the trader will initially have a Delta Neutral position.
Making Money due to Stock Movement: As the stock moves up, since you have a positive Gamma position, this means that you will quickly move back from being Delta Neutral to a Positive Delta position.
The Hedge (Scalp): Once the stock has moved up in value, your portfolio is no longer Delta Neutral, so you need to sell some of your Long Gamma position (which is long the underlying) to bring your Delta back to Neutrality. By selling when the stock has moved up, you will have locked in a profit on your hedge.
Stock Moves Back Down: When the stock moves back down, your Delta will return to being negative.
The Second Hedge: In order to bring your Delta position back to Neutrality, you will now need to buy some of the underlying stock you sold, but this time you will buy it back at a lower price than you sold it for, thus locking in another small profit on your hedge.
The Gamma Scalping Profit Engine's core is the "buying low" and "selling high" process, which occurs as the Delta of the underlying asset changes.
Advanced Strategies and Implementation
Professional traders use a wide variety of strategies and tools to maximise their profits from Gamma Scalping.
1. Optimal Position Structure
Long Straddles & Long Strangles are the most effective strategies for Gamma Scalping in volatile markets, but they also result in the highest Theta Decay costs.
By creating slightly Delta-Negative or Delta-Positive RATIO SPREADS, traders are able to lean into an expected direction while still being able to capture positive Gamma.
2. Execution and Rebalancing
To be effective, Gamma Scalping must have large trading volumes, and the accuracy of rebalancing is critical.
Rebalancing Frequency: Higher-frequency rebalancing will capture more Gamma profits. However, it can also lead to more Transaction Costs. Consequently, many traders apply Algo Trading systems to place trades whenever their Net Delta crosses a predetermined threshold (for example, 0.05).
Breakeven Goal: To be profitable using the continuous hedging approach, the overall profits earned from the hedges must exceed the combined costs of THETA DECAY and high Transaction Costs.
Join Our Option Greeks Online Course
Risks and Challenges of Gamma Scalping
Although gamma scalping is appealing because of its sophisticated character, it does not guarantee profits and so has considerable risk attached to it.
1. Theta Decay: The Silent Killer
One big risk is Theta Decay (Time Decay), where once you enter into a long gamma position through the purchase of options, you are continuously having time decay eat away at your position. This phenomenon occurs fastest when the options approach the money and also near expiration—this is when the greatest amount of time decay or theta decay occurs (the aggressive gamma position will make you the highest gains). Therefore, when using gamma scalping, a trader must always ensure that his gain from gamma exceeds the amount lost through time decay each day.
2. High Transaction Costs
Another risk incurred by gamma scalping is the associated high transaction costs incurred by making numerous trades (which may be in the range of tens of trades in a given day on the underlying asset) that allow the trader to maintain a long gamma position at delta neutral. For most retail traders, these high transaction fees (which include commission, exchange fees, and bid-ask spread slippage) are likely to consume most (if not all) of the gains made through gamma scalping.
3. Trending Markets (Trend Risk)
Lastly, trend risk (the risk that you will incur a loss due to a prolonged trending market) exists for gamma scalping. Gamma scalping is best suited for volatile/range-bound markets or zones. Therefore, if a stock begins to trend strongly in the same direction over a prolonged period (with little or no oscillation), the trader’s position can move quickly to a level far outside of the money. In such cases, the risk of loss increases due to directional risk, effective gamma drops significantly, and thus, the difficulty in hedging against delta increases significantly. Understand Risk Management in Stock Trading now.
Join Our Option Strategy Classes
Real Examples and Case Studies
In a recent case study, we will explore a simplified example of gamma scalping as it pertains to the stock of XYZ company (Ticker: XYZ). For example, assume you have established a delta-neutral long straddle position(s) on XYZ trading at $100. This position will have a net delta of 0 and a net gamma of $0.10.
Consequently, by utilizing the volatility created by a price swing (high-to-low) in XYZ stock, by selling high and repurchasing at a lower price, you generate a profit of $10. This profit serves as a hedge against the daily theta decay that occurs on the long straddle position. Understand Open Interest in Derivatives with the help of our blog.
Conclusion
Gamma scalping is an excellent option trading technique that requires practicing discipline, executing quickly, and having a proficient understanding of the Options Greeks. Generally, gamma scalping is used predominantly by institutional traders, market makers, and highly experienced retail traders who utilize algorithm-driven trading systems. The high volume of trading, combined with the very thin margins necessary to offset theta decay and transaction costs, makes gamma scalping impractical for most traders.
However, having an understanding of gamma scalping can yield a much deeper understanding of how volatility is traded and the mechanics of delta hedging. It also demonstrates to options traders that it is not necessarily the direction in which an underlying security moves that generates a profit, but rather how that underlying security gets to the specific price point that generates the profit.
Would you like to develop other, more advanced derivatives trading strategies?
-work.jpg)
.jpg)
