I am far from an Options Guru. In fact, I am a nobody in the Options world. I have, however, read thousands of pages of posts and taken hundreds of pages of notes. Read and reread Natenberg and Baird. There is no free lunch. There is a plethora of free information on this website in the archives. There are a few guys who used to post (one still does every now and then) on here who understand the greeks in and out. Yeah, they can be hairy? LOL- a little off track, sorry.. I used to talk to one regularly but I was basically a scumbag to him--I deserve everything that happened. It is never... I repeat, never OK to buy or sell naked vola... He tried to warn me but I had to lose a 95/100 binary bet on eur/usd on a 10lot to understand what he was truly talking about. You can be OK at direction and tear it up if you can fully grasp the Greeks.
If it is a stock that rises well above short strike, you will be short delta? 3500 shares? Add 1cent wings?
Let me try and run through this senario as it has been bothering me the past few days. "Neutral" doesn't seem so for very long. Of course this will require that some adjustments be made but first step is to understand what happens to the option price when one variable changes. First I want to examine the event that xyz rises and its effect on gamma. xyz is trading at 27 which seems appropriate relative to the values of delta and gamma. xyz rises three points to 30. Since gamma increases in value as the underlying moves closer to the strike the gamma in the xyz long call will be somewhat lower and higher for the long. Lets say a reduction of 0.02 for the long call and respectivly an increase of 0.02 for the long call. Had it been further from expiration the magnitude of the change in gamma would have been less. As xyz moved away from the long call it's gamma's value reduced. As xyz moved closer to the short call it's gamma's value increased. New Values for Gamma: Long 100 xyzCalls= ((0.08)100)100= 800 Short 125 xyzCalls= (-(0.1)125)100= -1250 Net Gamma= -450 So for each $1 move in xyz the delta of these two options will change by -450. Since we just saw the underlying move up 3 points the values of the deltas would have changed accordingly as determined by the values of delta at that point in time. The delta in the long call would now be 0.9 (0.1*3+0.6=0.9). The new delta for the short call is -0.64 (-0.8*3+-0.4=-0.64). But... since these values are ever so changing it slightly skews the numbers making my claim slightly off. New Values for Delta: Long 100 xyzCalls= ((0.9)100)100)=9000 Short 125 xyzCalls= (-(0.64)125)100)=-8000 Net Delta =1000 Still short 1000 shares of xyz, -not still neutral. Gamma is the rate of change in delta for every one point move in the underlying (I am reiterating this so it sticks in my head). So a one point move in xyz to 31 would change me from delta neutral to delta -450 plus the short position equals -1450. Another move in xyz to 32 would bring my delta to not -1900 but slightly less because gamma, as both options became further OTM, would be losing its value which in turn would have a lesser effect on delta. The extreme would be that if xyz rises very high with respect to the calls, thus their delta's would be closer to 1 and -1. The long call would have a delta value of just about 10,000 and the short calls would have a delta value of -12,500 netting me -1,250 plus the short position equals -2,250. So without adjustment is that the extent of leverage?!! Honestly I am confusing the shit out of myself and I have to stop looking at this for a while I've been stuck on this since yesterday. I don't understand why bother neutralizing gamma when you can just keep tabs on the delta and adjust accordingly. Why couldn't I originally (prior values of delta) just forget about gamma and buy 100 calls and sell 150 puts, no shorting the underlying and still neutral...and then just keep tabs as I would here? I am going to come back to this post in a few hours and probably answer my own questions if you guys don't already. Thanks for checkin this out, its hard to learn things alone I appreciate all the input.
I am having trouble just trying to put things in perspective when only a change in underlying occurs, all else equal. As soon as I get that through my thick head I will advance myself and look into the great points you bring up. Thanks
I don't know why you feel that you're confusing the shit out of yourself, you actually seem to have a very solid grasp of how all this works. Your scenarios for what happens when the underlying moves toward your short strike or your long strike or beyond are all spot-on. Maybe what you're missing is an understanding of why you would want to trade gamma and delta neutral in the first place. A good reason would be, for example, that you've found an anomaly in the skew. Let's say you're trading options on the S&P, where every strike trades at a higher IV than the strike above, and at a lower iv than the strike below. Let's say that one day, in a fit of bullishness, there's a mad rush to buy otm calls. Suddenly, all the otm calls are trading at the same iv. That's an anomaly, and you expect it to be temporary. So how do you play it? You could sell far otm calls, buy slightly otm calls, and wait for the skew to get back to normal, at which time you could take off your spread and realize your profit. In the meantime, you don't want to be exposed to a change in iv, the movement of the s&p, or time. So when you put this spread on, you do it exactly the way you initially envisioned - delta and gamma neutral. Then you try to manage it as delta and gamma neutral as possible until the skew goes back to normal and you can realize your profit. You would also keep in mind that as the S&P goes up, you get shorter and shorter gamma, and also vega. Since the IV on S&P options drops as the S&P goes up, that would work in your favor as well.
I am also breaking my head over this and tried lots of things, my main worry is IV rise, today it came to me that a calendar spread will offer the best protection I can think of, short call front-long call back or vica versa put. When IV rises or falls both legs kinda rise/fall the same, the difference is leveled by means of neutralizing delta. Also when the underlying moves the delta is neutralized. Your kinda synthetic suggestion in the above quote has unlimited downward risk which a calendar spread has way less. I am pretty new to this so I am not claiming to have a better solution, rather like to know what others think of my assumption that this could work.
Sounds very interesting and is starting to make more sense. So let me get this strait, you first recognize what you deem an "anomaly" in the vegas within a range of strikes. Sell the strikes where vega is relatively high and buy the strikes with low vega. Is this a sort of arbitrage? Since it is a play on vega you hedge against delta/gamma. If in fact as in this scenario you are short the further OTM's doesn't theta create a problem? Since theta's value is greater ATM, wouldn't the position create a discrepancy where theta will have a greater negative effect on the long calls than it would positive on the short? But then again if this is a play on vega it should not be held long enough for theta to have a great effect. Is that the case? Is vega actually predictable enough where it has a reliable mean reversion aspect to it?
It's only an arbitrage if the options you're buying and selling against each other are at the same strike - a conversion or reversal. Otherwise it's a spread, not an arbitrage I'm talking about doing this spread at a ratio that makes you gamma neutral, vega neutral, and theta neutral. In a nutshell, premium neutral. So you would be short more far otm calls than you are long atm calls. As you seem to understand well, this would make you short premium as the underlying rises. Since in the example I gave, iv would drop as the underlying rises, that's good. The underlying (the S&P) would go up, you would get short premium - including of course short vega - iv would drop and you would make money. It's also interesting to note that with this position, if iv drops first, you would get long deltas, and as the underlying went up you would also make money. Okay, here's where we need again to resolve your confusion over the point of delta-neutral, premium-neutral option trading. The point of such trading is to simply NOT LOSE MONEY ON CHANGES IN THE UNDERLYING, CHANGES IN OVERALL IV, OR THE PASSAGE OF TIME while you are waiting for some volatility spread you have put on to work. Let me give you some examples from when I was a local in the T-bond options pit, and always maintained my position delta and premium neutral. As a local (the futures exchanges' term for market maker), I was buying the bid and selling the offer. That was one edge. Since I was trading the back months, most of the options were quite illiquid. I'll give you a specific scenario. Let's say a broker comes in and asks for a market on the 100 calls. He doesn't say if he wants to buy or sell them, because then we could adjust our markets accordingly. So we give the broker a market of .50 bid at .52. He sells me 100 at .50. Now, if a second later another broker came in BUYING the 100 calls, I could sell them at the offer - .52 - and make a 200-tick profit. But these options were not that liquid. It might be a week or a month before somebody would come in wanting to buy those 100 calls. In the meantime, while I was holding those 100 calls in my inventory, the last thing I wanted was to be exposed to delta risk. So the moment I bought those 100 calls, I would turn to the futures pit, signal my broker, and sell futures to become delta neutral. So far so good. But I'm still long premium. I'm still exposed to theta risk, gamma risk, and vega risk. So now I'm interested in selling premium to become premium neutral. If I can't sell it at the 100 strike, I'll look to sell it somewhere else. Let's say a broker now comes in looking for a market in the 102 calls. The locals give him a market of .30 bid at .33. I really want to sell some premium, so I offer them at .32. The broker buys a hundred. I immediately turn to the futures pit and buy futures to make myself delta neutral again. Now I'm long 100 100 calls, short 100 102 calls, and short futures at a ratio that makes me delta neutral. The futures are at 101 - halfway between my long 100 calls and my short 102 calls - so I'm premium neutral as well. Later that day, let's say that iv is down. But the iv relationship between the 100 calls and the 102 calls hasn't changed, so I have not made or lost money. I'm just waiting for someone to come in wanting to buy the 100 calls so I can sell them at the offer, and someone wanting to sell the 102 calls so I can buy them back at the bid. If I do so, I'll realize a profit. So basically, the job of a market maker is to buy wholesale and sell retail, while neutralizing all the other extraneous factors such as movement in the underlying, movement of IV, and the passage of time. In real life, you don't stop after you've bought the 100 calls and sold the 102 calls. You keep on making markets all day long. For days at a time, all your trades may be opening positions. So your total position grows really fast, and before you know it you add up all your longs and shorts and it comes out to 5000 or 6000 options, against several hundred long or short futures. That's why you have to know your greeks cold - it's the only way you could possibly manage such a position. Without them you would have no idea where you were. As a retail trader you can't buy the bid and sell the offer. But what you can do is become very familiar with all the IV relationships - strike to strike (the skew), month to month, etc. Then, when those get way out of line, you can buy the cheap one and sell the expensive one at a ratio that gets you premium neutral, and buy or sell the underlying at a ratio that makes you delta neutral. When the IV relationship comes back into line, the idea is to take off your spread and realize your profit.
Now thats really facinating, I had no idea how things really work for a MM. Not to get too off topic but do newly hired MM's have a high fallout rate? I mean it seems like a couple wrong moves and you could really be wiped out. Or is there a world of preliminary requirements before you are given the responsibility? Pretty cool stuff though. I'm going to read what you wrote again and just re-think the trade. I'm getting there.