The traders use the Gamma neutral options trading strategies to construct positions with a zero or nearly zero gamma value.
Options trading make use of Greek values such as delta and gamma to predict the changes in prices of options.
Gamma is one such option Greek that identifies the rate at which the delta value of an option changes. It is concerning the movements in stock price.
The gamma neutral strategies that aim to keep the gamma value closer to zero have to ensure that the delta value remains neutral.
It should be so despite the changes in the price of the security. There are positive and negative gamma values.
Now, the traders can get a positive value by owning call or put options. It happens while selling call or put options can bring a negative gamma value.
The traders have to balance the buying and writing of options to gain a neutral gamma value.
What is Gamma Neutral Options Trading?
The gamma neutral trading is a technically complex strategy we recommend only for experienced traders.
The complexity of the method lies in the technique of balancing the options. If gone slightly wrong, it can result in losses.
There are various strategies or calculations to establish a gamma neutral position. The traders have to creatively combine the options to establish the position.
The gamma neural trading strategies along with providing profits also have the potential in protecting positions.
It is since maintaining low gamma value implies that options positions remain unaffected by the changes in stock price.
Moreover, traders who wish to reduce the volatility of the options also try to create a neutral gamma value. It is so the value represents the volatility of a trading position.
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Gamma Values in Gamma Neutral Option Trading Strategy
The gamma value of an option is a measure of the changes in delta value depending on the movements in stock price, which is the gamma values helps the trader in calculating the rise in delta value for every Rs.1 increase in stock price and the decline in delta value for each Rs.1 decrease in stock price.
The gamma value of a call or put option is usually at its high point when the options are at the money. When the options move further into the money or out of the money, the value decreases.
- An out of the money call option has a delta a value 60 and a gamma value 20.
- Consider Rs.1 fall in stock price, simultaneously the call option would fall by Rs.60 making the delta value 40.
- A further decrease in the stock price would result in a big decline in delta value and therefore the gamma value as well.
The gamma values remain positive on buying options and become negative on writing options. Traders can make profits when the price of the underlying security increases if the delta and gamma values of positions are positive.
On the other hand, if the position has a positive delta and negative gamma value then the traders do not have a chance of gaining profits throughout the increase in stock price.
The negative gamma value indicates a decreasing delta value and this can completely overturn the profiting situation once the delta value drops beyond “Zero”. Here the trader has to identify the maximum possible profit and seal the position at that particular point.
Theta is another major option Greek that changes according to the changes in the value of gamma. This relation between gamma and theta is significant as it can influence generating profits from the effects of time decay.
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Constructing a Neutral Gamma Value
Constructing a neutral gamma value depends only on the combination of options that we buy or sell.
One of the fundamental knowledge that the trader needs to have to make a proper combination is regarding the options that produce positive and negative gamma values.
We can describe this information in the following manner,
- Positive gamma– Long call options with positive delta values and long put options with negative delta value generate positive gamma values.
- Negative gamma– Short call options with negative delta and short put option with positive delta creates negative gamma values.
Here is a hypothetical example to create a gamma neutral position,
- A company is trading at Rs.100 and its call option A has a gamma value 0.23 and has another call option B with the gamma value 0.42.
- The traders have to buy 42 contracts of call option A and simultaneously sell 23 contracts of call option B to create a neutral gamma value.
- 42 x 0.23 (total gamma value of bought call option A) – 23 x 0.42 (total gamma value of sold call option B) = 0 (total gamma value).
- The number of options owned and sold by the trader depends on the gamma values.
The Need for Gamma Neutral Option Trading Strategy
The experienced traders use gamma neutral option trading strategies to minimize the volatility of the option position.
They try keeping the delta value constant, to generate profits by analyzing the implied volatility. They also focus on points to protect the profits obtained using volatility.
We have further discussed these three main purposes of creating gamma neutral value here in detail.
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The volatility of position in Gamma Neutral Option Strategy
The basic relation between gamma and volatility is that the gamma value of an option position describes the volatility.
The traders can effectively reduce the exposure to the volatility of position. They can do so by bringing the gamma values to zero or nearly zero.
Traders can construct a position that is gamma neutral and delta positive. It is to obtain a fair amount of profits from the stocks.
This is largely useful for traders who are interested in keeping the underlying security for a longer-term. They can try to mitigate the risks coming out of volatility of positions.
The implied volatility of an option refers to the volatility of the underlying asset. It is usually predicted or expected by the traders. The implied volatility is estimated based on factors like stock price, interest rate, strike price, expiration, etc.
The gamma neutral and delta neutral positions provide a great opportunity for the traders to trade in volatile positions.
Theta is yet another option Greek that changes according to the changes in the value of gamma. So, we cannot use it to make profits.
On the other hand, the option of Greek Vega remains unprotected. It changes even in a delta neutral, gamma neutral position.
Then, the option position becomes long Vega in such conditions. This would create a neutral position that remains unaffected by the changes in stock price. It does so while generating profits from the increase in implied volatility.
However, one can use this method only if the trader can predict some sort of movement in the implied volatility, while not being able to anticipate the direction of movement in stock price.
One of the most popular benefits of gamma neutral trading strategies is the sealing or protecting of profits made so far by the trader.
As mentioned earlier in this text, there can be situations when the trader might lose all the profits gained so far, if they continue to further. The traders can protect the profits obtained using these gamma neutral strategies.
A delta and gamma neutral trading position naturally has a neutral theta value, as a result of which the trading position is protected from price changes from time decay.
The largest benefit of this gamma neutral hedging strategy is that it can effectively protect the profit gained, while simultaneously yielding additional profit from the volatility of the position.
This strategy is also helpful if the trader is not able to predict the direction in which the stock price might move.
Gamma Neutral Options Trading Strategy – Conclusion
Gamma is one of the options Greek values that we use to identify the possible changes in delta values. It depends on the movement in stock price.
The gamma neutral option trading strategy is what we use to construct a gamma value that is zero or nearly zero.
It is to make sure that the delta value remains constant despite any movement in the price of the underlying asset.
Traders can create a neutral gamma value by logically combining the positive and negative gamma values.
However, the critical thinking and the related transactions involved in the trading strategy makes it a complex process and is therefore not considered suitable for beginners.
The traders use gamma neutral values to reduce the exposure to the volatility of the trading position. Similarly, we also use this strategy to generate profits. We do so by trading using the implied volatility of a position.
The gamma neutral strategy is also best if you want to secure the profits obtained so far in trading. All these features of the gamma neutral option trading make it popular among the experienced traders.
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