[Gamma] Scalping Please

Mat Cashman, Principal of Investor Education at the OCC, joins Jeff Praissman to talk about the advantages and disadvantages of trading using a Gamma Scalping strategy.

Corresponding Webinar:  https://ibkrcampus.com/webinars/gamma-scalping/

Summary – IBKR Podcasts Ep. 152

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Jeff Praissman 

Hi everyone, I’m Jeff Praissman. It’s my pleasure to welcome back Mat Cashman. Mat is a Principal and Instructor at the Option Industry Council.  

Welcome back to the IBKR podcast studio, Mat. 

Mat Cashman 

Thanks for having me. I’m happy to be here to talk about Gamma. 

Jeff Praissman 

Oh, it’s my pleasure. Mat, you’re a frequent contributor to our podcast series and webinars. In fact, you actually just finished up a great webinar on Gamma Scalping, and I’m excited to take this opportunity to continue the discussion in this podcast. 

Gamma Scalping is a fascinating concept. But before we kind of dive into the depths of the strategy, I’d like to take a moment to understand the fundamental concept of Gamma.  

For our listeners, Gamma in the realm of Option trading is one of the Greeks. It’s a set of metrics used to measure various factors affecting the Option prices. Gamma specifically measures the rate of change in Options Delta in response to changes in the pricing of the underlying asset. 

Mat Cashman 

Yeah, that’s absolutely right, Jeff.  

Delta- let’s start with Delta also, right? Just to recap for people. Delta represents the sensitivity of an Options price to changes in the price of the underlying asset. So when we talk about Gamma, we’re actually talking about how fast Delta changes in response to those same movements in the underlying asset price essentially. 

Jeff Praissman 

Yeah, that’s absolutely right, Mat. And for anyone who listened to our previous podcast, Episode 139, No Math, No Problems: Learning Options From Metaphors, another great way to learn about these concepts through a non-traditional way.  

But let’s go back to the subject here I guess because it’s important to note that Gamma can be either positive or negative.  

For our listeners, a positive Gamma means that Delta increases as the price of the underlying asset rises and decreases as it falls. But conversely, a negative Gamma indicates that the Delta decreases as the underlying asset rises and increases as it falls. 

Mat Cashman 

Yes, that’s absolutely right as well. One of the things that I like to talk about an awful lot when I talk about Gamma and specifically about Gamma of Options is that the Gamma of an Option is always expressed as a positive number.  

So a lot of times there’s a little bit of confusion for people when you actually express that as a positive number when you’re looking at it on your screen and it’s positive. And then they ask questions about like well, people talk about negative Gamma all the time. How do you get negative Gamma? Positive and negative Gamma comes from what you actually do with the Options.  

So if you’re long Options all the time and all you do is buy Options, you are going to be long Gamma. And if all you do is sell Options and you sell those rights to other people, you are going to have what we call a short Gamma position.  

So Gamma of the Option itself is expressed as a positive number, but Gamma positions can actually be positive and they can be negative. Now, positive Gamma positions tend to benefit from volatility of the underlying and uncertainty in the marketplace. And negative Gamma Options can be a little bit more vulnerable to sharp price movements back and forth.  

And the reason why is because the actual Gamma of the Option is what changes the Delta of that Option. So if you own that Option and you own that Gamma, you’re the person who actually owns the rights back and forth when the underlying is moving back and forth as the Delta of that Option changes.  

And if you’ve sold that to someone else, you have what we call short Gamma and you’ve sold that right to them. And so you don’t want that amount of underlying movement to happen for your position. 

Jeff Praissman 

Yeah, that’s great, man. And it’s obviously super important for this podcast even before we get into Gamma Scalping to understand Gamma. 

And now that we’ve brushed up a little bit on our Gamma knowledge, I’d love to delve deeper into this concept of Gamma Scalping.  

Mat, could you talk to our listeners on exactly what Gamma Scalping is and how it operates? 

Mat Cashman 

Yeah, absolutely. And I just finished talking about this on the webinar and it’s something that’s a little easier to see in front of you, but I’m going to try to give you an idea of what it’s like just from hearing it in the webinar, right?  

Gamma Scalping is a trading strategy that is employed by Option traders to profit from the Gamma exposure of their positions. So essentially it incorporates trading, continuously, buying and selling of the underlying; the stock or the commodity or the index or whatever you’re trading that the Options are priced on.  

And you’re buying and selling the underlying in order to maintain what we call a Delta Neutral position or a Delta Neutral portfolio. And theoretically what you’re doing is you’re capturing profits from buying or selling that underlying from the changes in the Delta of your Options position that’s coming from the Gamma, as the underlying moves back and forth and the buying and selling of that underlying is what the actual profit in the profit and loss comes from, as far as Gamma Scalping is concerned.  

That’s where the actual scalping is happening. So sometimes people look at it and say it’s not really Gamma Scalping, but because you’re actually trading underlying, the answer to that is okay, yes, that’s true. It’s not technically Gamma Scalping.  

You’re actually scalping the underlying, but the Gamma is what you’re trading that underlying position against back and forth. 

Jeff Praissman 

So the investor or trader is really just taking advantage of the fluctuations and the sensitivity of the underlying prices relative to those changes in the Option prices as this goes on? 

Mat Cashman 

Exactly. That’s exactly what’s happening. And by adjusting your positions Delta through that frequent trading of the underlying, how much stock you’re long or short relative to your Options position, you can actually profit from smaller price movements in the underlying asset while you’re actually minimizing the exposure to changes. And things like volatility and time decay that are inherent within an Options position. 

Jeff Praissman 

So that’s an interesting point. And with Options, obviously you have your strike price, you have your premium and you have your expiration month. And I’d like to know how the duration of an Option, how does that affect its relationship to Gamma?  

How does the duration of an Option, whether it’s short term or long term, what effect does that have on Gamma? All things being equal. 

Mat Cashman 

Yeah, that’s a really good question. I think there’s one real, kind of general rule that you can use here. And that is essentially that as the duration of an Option gets shorter, as it gets smaller and smaller and smaller, the actual Option itself is more sensitive to underlying movement, particularly when it’s an At The Money (ATM) Option or something that’s close to At The Money.  

And so the way that I like to talk about this and think about it is that the shorter an Options duration is, the more Gamma it has, that means the more sensitive it is to underlying movement. Oftentimes, when I’m talking about this, what I’ll say is if you’re looking for the Option on the board that has the most Gamma you can find in it, you really need to look at A: At The Money Option and B: you need to look at the Option that has the shortest amount of time between now and the time that it expires.  

So many times people will utilize things like 0DTE Options which are actually expiring the day of their trading.  

For things that they’re looking for as far as Hedging, where they need lots of Gamma exposure because those Options, particularly if they’re At The Money Options, are going to be the Options that have a very high Gamma profile, as far as their risk is concerned. 

Jeff Praissman 

So why is that? Why does that, pending when the expiration is, really affect the Gamma in that way?  

Mat Cashman 

Well, the Options that have shorter durations have less time, right, for the underlying to actually move significantly.  

So when you take that into account, any price change that happens is going to have a more significant impact on the Options Delta. And that’s really what determines how much Gamma an Option has.  

Remember, Gamma is a measure of the rate of change of an Options Delta. So if you’re dealing with an Option that only has six hours left until it expires and the underlying moves a significant amount underneath it, the actual Delta of that Option is going to change significantly between the time that you’re looking at it and the time that it expires.  

Because it’s actually expiring in six hours, right? I mean that’s how Gamma is measured. And that’s what Gamma actually means. It’s the rate of change of the Delta. 

Jeff Praissman 

Let’s get back to Gamma Scalping then. Would the traders prefer Options with shorter durations to capitalize on these higher Gamma values? 

Mat Cashman 

Well, I think the answer to that question inevitably is it depends. While shorter duration Options offer higher Gamma profiles and higher Gamma potential, they also come with increased risk.  

Many times when I’m talking about, you know, my job is to always talk about the risks and the actual benefits of Exchange-Traded Options. This is one of those situations where Gamma itself has its own risk and its own reward, right?  

It is when people are looking at short duration Options, they might want a higher Gamma profile or potential, but they also come with the risk that is inherent within their limited time to expiration. Traders need to balance and carefully balance Gamma exposure that they’re looking for with other factors that are the other side of that coin, which inevitably is time decay and things like exposure to volatility and the underlying movement that’s inherent within the underlying. 

Jeff Praissman 

There’s no reward without risk, and there’s no risk without reward. Or at least you shouldn’t take any.  

I’d like to kind of explore the potential or specific risks and benefits of Gamma intensive positions that traders might use for Gamma Scalping. What are some of the advantages and disadvantages of this particular strategy? 

Mat Cashman 

So the main advantage of having a Gamma rich position or a Gamma intensive position, particularly on the long side is that if you are long a decent amount of Gamma, what you’re going to have is the ability to profit theoretically from small price movements in the underlying without being significantly exposed to changes in volatility or time decay. 

What that really means is that the Gamma rich positions are going to give you leverage to be able to trade the underlying back and forth when that underlying moves, either away from your strike or in a way that gives you a Delta position that you can actually hedge by selling or buying stock. 

Jeff Praissman 

I mean that seems like a powerful advantage, but I have to assume there’s got to be some risks as well. 

Mat Cashman 

Yeah, absolutely, right? That’s the side of the coin that is the advantage of that.  

When we talk about Options, we always talk about what’s the cost here, right? And what the cost is, you can’t get an exceptionally large Gamma position without having to have risks that are associated with it.  

Many times what you’re dealing with is that you’re going to have a Theta position that is commensurate with the amount of Gamma that you have for those Options. Remember, Options that are short in duration and are At The Money are going to have a significant amount of Gamma in them.  

If you’re long that amount of Gamma, you are actually going to incur the Theta that comes along with it, because if you’re dealing with the short duration Option, that Option’s going to expire in a very short period of time. And all of the extrinsic value that’s associated with that Option has to go to zero before it expires. That’s how extrinsic value actually works. 

What’s actually leftover is just the intrinsic value of that Option when it expires. And, so,  having large Gamma positions inevitably, if you’re dealing with short duration Options, comes with a large Theta position that is the other side of that coin. 

Jeff Praissman 

Gamma Scalping is really a strategy that requires a lot of precision and vigilance by the investor or trader. 

Mat Cashman 

Absolutely. Yeah. Gamma Scalping isn’t necessarily for everyone, but traders who understand the nuance and the intricacies of it and can manage those risks, it can be a really valuable tool in the arsenal that they use to look at how they should manage their risk. 

Jeff Praissman 

And Mat, finally, I’d like to talk about a term that maybe many of our listeners aren’t really familiar with, and that’s Hard and Soft Delta. 

It’s not something that I think a lot of people have heard. I’d like to discuss how they relate to Gamma Hedging and implied volatility and also just define them to the listeners as well. So the ones that aren’t familiar with those terms can get an idea of what we’re talking about as well. 

Mat Cashman 

Yeah, absolutely. Hard and Soft Delta is something that takes a little bit of time to actually understand how and why it exists. But once you understand it, it’s something that can really color how you look at Premium and Options Premium in general.  

And it’s an interesting concept. It’s one of those things that comes from people who actually are market makers and people who take on positions that have inventory and all kinds of strikes that have to actually evaluate their risk from a really holistic perspective. 

They have to look before they start buying or selling stock against what they see as Option Delta. They have to think about whether or not that Delta actually exists in a way that’s going to be hedgeable with a stock position. And whether or not that’s going to increase or decrease their variants. 

And what I’m really talking about here is, let’s start with Hard Delta. If you assume that stock is like the ultimate in Hard Delta, right? Stock moves one for one with the stock, right? That sounds like a truism, and it is a truism. But that’s really what it is. That’s the ultimate in Hard Delta.  

When you’re dealing with Options, you have to evaluate what I just talked about, which is extrinsic versus intrinsic value of the Option. Any Option is going to have a certain percentage of it that comes from extrinsic value and a certain percentage of it that comes from intrinsic value right up until the point where it expires. When it expires, it’s all intrinsic value. And no extrinsic value is left in it. But why I bring that up is that when you talk about Hard Delta, Hard Delta to me is like a measure of how direct or linear the relationship is between the Options price and the underlying assets price, movement wise. And it doesn’t necessarily take into account factors like implied volatility movements and things like that as far as the Option is concerned. I tend to think of it more like, the more an Option is in the money, the more that Delta that you’re seeing from that Option can be considered what I would call a Hard Delta, meaning it can be hedged more with the underlying stock without creating underlying variance to the P&L of the position. That’s kind of how the Hard Delta part of it works. 

Jeff Praissman 

The definition of Hard Delta. We all have to assume that Soft Delta is more Out Of The Money, but how does it differ? 

Mat Cashman 

If you think about Hard Delta as an Option, the more In The Money the Option is, the more Hard Delta it has. And when I say Hard and Soft Delta, I have to put air quotes around Hard and Soft Delta because it’s kind of a nuanced idea and it’s difficult to get that across in a compliant way, to be honest with you.  

Soft Delta, on the other hand, is going to incorporate more of the impact of changes of implied volatility. It’s more of what I call “Option Delta”. Like it’s a Delta that exists but is not necessarily always going to be hedgeable by the underlying.  

So I want you to think about it this way. If a stock is trading $50.00, the $35.00 call, which is significantly In The Money, a large part of it is going to be intrinsic value and a very small part of it is going to be extrinsic value. 

And that Option is going to represent something that’s very close to Hard Delta. Because it’s very In The Money. If the stock’s trading $50.00, conversely, something like the $65.00 or the $70.00 call is going to be something that I would consider much more Soft Delta. 

Meaning that Delta isn’t necessarily something you can hedge with an underlying short stock position against it without increasing the variance of the P&L of the position. Because if the stock were to stay at $50.00, the $65.00 call is eventually going to be Out Of The Money.  

And your stock position, if you carry a short stock position against that $65.00 call Delta, your stock position doesn’t necessarily expire at the same time your Option expires. And, so, what you’re left with is Option Premium that is expiring and thus the Delta associated with it is expiring and coming off of your sheets.  

And the short stock that you have against it isn’t necessarily expiring. And that’s why when I say when you hedge Soft Delta with underlying stock, you can get yourself into a situation where you’re actually increasing the variance of your position. 

Jeff Praissman 

Why are these distinctions important for the Gamma Hedging strategy? 

Mat Cashman 

When you’re talking about Gamma Hedging and Gamma Scalping, it’s important that traders consider both Hard and Soft Delta to effectively hedge their position against changes in things like implied volatility, things like underlying movement.  

You need to understand the nuance of how the Option that you’re actually Hedging is transitioning from Soft or Hard Delta to the other side- Hard or Soft Delta. Because what’s happening is a certain percentage of that Options value is always transitioning from extrinsic to intrinsic or intrinsic to extrinsic value. And that’s where the actual Gamma of the Option comes from. It’s the change in the Delta of that Option. 

And, so, if you’re thinking about taking on a strategy like this, it’s really important that you understand how the actual nuance of that transition, from an Option potentially being In The Money to being Out Of The Money or from being Out Of The Money to being In The Money is going to change what the Delta of your position is.  

Because that’s where those changes are occurring and that’s actually what you’re hedging when you’re buying or selling underlying. When you’re buying selling stock, for instance, against a stock Option that has Gamma.  

That’s really what you’re trading. The actual movement of the Delta back and forth or the Gamma. And so it’s really important that you understand how Hard and Soft Delta and In The Money versus Out Of The Money actually work relative to the Options valuation. 

Jeff Praissman 

Yeah, Mat, this was great.  

First, I want to thank you for stopping by the studio after the great webinar you just did, which our listeners can find the links to in the study notes.  

Thank you for all your contributions to our education. And just remind our listeners that they can access all our IBKR podcasts on our website under Education or on their favorite audio service like Spotify or Apple Music or Amazon.  

You can access webinars previously aired under Education, look for Webinars, look for our contributors, OIC.  

And again, a huge thank you to Mat for sharing his expertise with us. Thank you, Mat. 

Mat Cashman 

Absolutely. It’s always a pleasure to be here. Thanks for having me.