Theta scalping?

Discussion in 'Options' started by CalPumper, Aug 21, 2005.

  1. CalPumper


    I stumbled across an idea that strikes me as rather intriguing - selling premium in options (SPY perhaps, many other possibilities), and hedging it with e-mini futures. So one would sell x number of calls in SPY and go long the requisite number of e-mini contracts to get at delta neutrality. Seems like one would effectively be able to collect theta with little risk.

    Any thoughts on this as a viable strategy? Thanks again to those who helped me (Maverick, et. al.) in another thread regarding any inherent advantage to buying or selling options - I feel like an idiot in that regard, but better to feel that way than continue down a road paved with false assumptions.
  2. It's a delta hedge, but not theta. Gamma risk is the inverse of theta gain. The relationship is nearly linear. It's done every day in every option post/pit extant.

    You're replicating a short straddle when trading ATM options -- selling an SPY atm call would require 50 shares of SPY to flatten-delta, and would result in a synthetic straddle. The risk away from the strike[itm or otm] results in trading into the trend; either increasing gamma risk through hedge-reduction[strike-otm] or increasing risk through a larger hedge req[strike-itm, SPY risk].

    Reduced; the risk is as you trade further from the strike the risk is magnified as you're matching gamma-position with spot. As you do that, you risk mean-reversion to the strike, which carries the peak of the gamma convexity and risk. In summary, you're gamma-risk increases the further you move away from the strike.

    If you trade the spot well you'll do well trading short gamma/vol.
  3. You sound like you really know your stuff. It's all greek to me though.

  4. I'm not trying to complicate it, but unless it's dissected it always seems to look like a method to print cash. If the implied distro > the realized spot distro you'll probably earn, but it's no panacea. It's at least as risky as simply selling an ATM straddle. In the majority of scenarios you're probably better-served to sell the atm straddle and buy wings, or offset the straddle.
  5. CalPumper,

    you're a quick learner and it is always fun to see someone take the hurdles toward understanding options more fully. But I would really recommend you to read a few books on option-strategies, pricing and synthetics. It will take you a month or two to read them and another year to start comprehending, meanwhile losing a little in the markets (paper trading won't do), but believe me, it is the fastest road.

    Your next question will be, can you recommend etc. etc..

    For basic strategy there are a lot of books, notably McMillan and Fontanills, although both do have disadvantages. For pricing I would recommend Natenberg of course and for synthetics Cottle is best, although you'll need to do a search for the pdf since the book isn't sold.

    Anyway, good luck and have fun,

  6. cosine


    I find the explaination quite arid too.

    The thing, calpump, about what you described is that once delta hedged, an option is still exposed to gamma, which is due to convexity of option in spy's price. As spy moves, you incur losses due to this convexity. There is no free money in finance: as you cash in theta, you lose on gamma, which is the no-arbitrage argument behind black scholes' PDE (see In order to have a perfect hedge, you need to continuously rebalance your delta position. The result is zero expected profit (minus transaction costs, of course).

    What riskarb says further (correct me if I'm wrong) is that in the real world, prices may mean-revert. That adds a problem to your strategy. As gamma is higher around the strike, prices mean reverting around the strike will make you incur even larger losses as you rebalance your hedge. Thus the idea that selling an at-the-money straddle might very well end up being more simple and less expensive than a dynamic hedge.

  7. CalPumper


    I recognized when I posted it that there were more than likely some underlying flaws to the strategy, namely the need for rebalancing to remain delta neutral. Interesting to hear about the 'convextivity' of the gamma curve (apologies if I butchered the spelling). Would that inherently mean that theta has a concavity curve, I ask myself? Lots of these concepts are tough for a non math wiz to grab a hold of.

    MajorU, thanks for the book references. I actually own Natenbergs book. Clearly I need to review the sections on gamma - I'd like to think that its the one piece of the puzzle I don't fully appreciate or understand. In fact, I remember reading something about a strategy known as 'gamma scalping' and kind of borrowed the scalping bit for the title of this thread. Don't have a clue what gamma scalping is, and think I read something to the effect that it really isn't a viable strategy any longer so I didn't pursue it further.
  8. cosine


    Gamma's curvature oscillates between convexity and concavity, depending on the spy's price. When gamma is convex, theta is concave, and vice-versa.

    Gamma curvature is mostly useful for exotics and portfolios of vanillas. Dont bother with it for a single vanilla.

  9. I actually employ this monthly and have done well. I use near-month e-mini futures options, hedged with the nearest e-mini contracts. It might appear to be an easy money-maker, but it is not, for several reasons:

    1. E-mini futures options are margined according to SPAN. SPAN requirements are more realistic than the margin req for stocks and even efts like SPY. SPAN margin can be much, much less than margin for CBOE products like SPX and OEX options. Still, SPAN margin req can and do change daily, depending on vol and price movement, among other factors. On a large market move, margin calls are a definite risk. Start small, in other words.

    2. Gamma and therefore delta pick up on the options right before expiration. Thus, you can easily find yourself long or short a number of e-mini contracts unless you're prepared (Theta decay is nice, but it comes with a price). Closer to exp I tend to protect the short option positions by turning them into iron butterflies or iron condors, esp on the put side, or just winding the position down, rolling over to next month's.

    3. There is no holy grail in this business for us retail traders. You probably know that, but some still are out there looking for a sure-thing. It is not there.
  10. Gamma scalping == what you call theta-scalping.

    As said, I urge you to read the book again. As long as you don't understand the basics of that book it is useless to come here with questions about self-construed new plans. Believe me, sharper minds than yours (and mine) have been over all of this for years and years. Try to learn what they have come up with.

    #10     Aug 22, 2005