GATrader, Thanks for the suggestion and input, I will try to find the book. Maybe it will help clear up my confusion about gamma trading.
Eldredge -- no problem, gald to help. Sigma is standard deviation. Long gamma traders earn from hedging, short gamma trading only hedges to stem potential losses. IOW, the long gamma trader is hedging against the trend, short gamma trades with the trend -- therein lies the problem, short gamma trading lends to whipsaws on hedging. But we're talking long gamma here... let's assume you're long the NDX 1400 straddle from 70.00. In hedging intraday, I would run my analysis which give me hedging points which roughly equate to 1/3 and 2/3 of the average daily range of the underlying, oscillating from the prior close -- these are rough approximations -- and it depends on my underlying position -- I hedge straddles using an algorithm that differs greatly from what I use to hedge other long gamma positions. Effective hedging is where the trader pays his "gamma loan" -- you need to find a hedging strategy in which you feel comfortable, whether intra/interday. Always know your daily thetas(decay) in dollar-terms -- your immediate goal is to earn your daily decay, and if you do, you'll be holding pure long gamma/vega. arb.
A fairly quick read, "Option Market Making" by Baird. Finer points discuss gamma trading and time spread risks. arb.
About the only way I learn anything is by trying it, so I put a few of these positions on to see how this strategy would work in real time. I thought I would post my results in case anyone was interested. I decided to put on three or four positions of just one contract each, and open a new position when an old one hit the risk-free zone. These were all December contracts. I purchased MRK 40 for 2.20 and later sold stock at 42.49. I covered the stock at 44.51 and sold the straddle for 4.50. Net profit was 23.00. I shorted the stock way too early, and I decided to start buying/selling stock at the strike plus paid premium plus 1% of the strike price from now on. I purchased NXTL 25 for 1.60 and sold it for 1.00. Net loss 64.00. I purchased CSCO 22.5 for 1.30. Shorted the stock at 23.98 and covered at 24.16. Sold the straddle for 1.70. Net profit 16.00. I bought GCI 90 at 2.40. Bought stock at 86.72 and closed at 87.53. Sold the straddle at 2.50. Net profit 85.00. I bought KSS 45 at 3.10 and sold it at .20. Net loss 294.00. I bought SUN 50 at 1.70. Bought Sun at 47.49, sold at 50.15, shorted at 52.20, and covered at 52.05. Sold the straddle for 2.10. Net profit 309.00 I bought VSH 22.5 for 1.35. Bought VSH at 20.94, and sold at 22.23. Sold straddle for .35. Net profit was 23.00. So, net profit was 97.00. Probably not worthwhile. BUT, if this was a typical month, I wouldn't mind doing this while hoping to catch a huge move in one of my positions. Also, if I would have purchased two contracts when they were under $2 (to equalize exposure a little). I would have had about $400 profit. Also, these positions allowed me to offset some of the risk of some other positions I had open (a naked straddle, and some spreads). Bottom line, I don't know if I will do any more of these or not.
Elderedge..let me get this straight, you were buying 2 calls and hedging by taking opposite on the stock and you were positive? That is good considering the vols have been coming in the past few months. In addition, you strategy opens yourself up for those occasional homeruns. Imagine if 10% of your position had bad news, takeover,etc. You might want to experiment with this further and not give up.
I was actually buying a straddle and then buying or selling the stock when it had moved far enough to cover the cost of the straddle plus a small profit. At this point I had a risk free put or call. If the stock price moved back to the strike price, I would cover and own a risk free straddle. Like you said, the chance of catching a huge gap is what might make this more profitable in the long run.
If you could pick the right candidates and show consistency, this strategy would be a nice complement to other strategies since it is a basically a set and forget system (forget up until a certain loss threshold is reached. In fact one can take this set and forgt to an extreme and put in bids/offer on the straddle, put in bids offer on the gamma scalps.High margin though expecially in stocks.Good luck. Read up on Cottle or Baird as riskarb posted a while ago.
Eldredge, Here is a paper on ATM straddles that might interest you: http://www.mfainfo.org/images/pdf/report.pdf I'll PM you with some other thoughts on the simple strategy.