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If you’ve been paying attention to the financial news this week, you have certainly seen the incredible rise of the shares of brick-and-mortar video game retailer GameStop (GME - Free Report) . You may have also heard that much of the price action in those shares is due to options trading rather than simply buying pressure in the shares themselves.
I scratched the surface of this phenomenon – often referred to as a “gamma squeeze” - on Tuesday for Zacks.com.
If you’re here reading the Know Your Options column, you’re probably interested in a more in-depth look at how gamma affects trading behavior as well as whether there are opportunities for individual investors in GameStop options.
Read on…
Delta is the sensitivity in an option’s price to a move in the underlying security. Gamma is the sensitivity of an option’s delta to a move in the underlying security - basically “how much will the delta change when the stock moves?”
Most individuals who are using options to speculate on the direction and magnitude of a move in the underlying or to generate income by selling options against their other holdings don’t pay much (if any) attention to gamma, but the professional market makers that are your likely counter-party on every trade pay very close attention.
There are thousands of stocks listed with tradable options. With many strikes and expiration cycles listed for each stock, there are tens of millions of contracts available for trading on any given day. In all but the most liquid and active short-term options, the bid-ask spread you see on the screen has been provided by a market maker.
In general, those market makers aren’t interested in taking a position on the direction of future moves in the underlying. Primarily, they want to collect that bid-ask spread. If the market for a call option is $4.80 bid at $5.00 offer and you buy one option for 5 bucks, the market maker who sold it to you doesn’t start hoping for the stock price to fall so that he can collect the entire premium you paid as the option expires worthless.
In fact, the best thing that can possibly happen to him is that someone else comes along immediately and sells him the same call option on the $4.80 bid. The market maker books a quick profit of 20 cents - $20 per contract for US equity options – and has no position (or risk) left on his books.
That tends to be unlikely however, so the market maker will likely hedge the trade against movement in the underlying buy buying shares to offset the delta of the short position. If the call option you bought had a .25 delta – meaning that its value will change by 25 cents if the underlying moves a dollar – the market maker will buy 25 shares of stock, making the total delta of his position zero. He is indifferent to small changes in the underlying price in either direction.
(I used “.25” to express the delta because delta is a percentage. From here however, I’m simply going to shorten it to “25” because that’s the way traders would describe it.)
Notice I said “small changes.” If the stock were to move a larger amount, the delta of the option changes and the market maker who wants to remain delta neutral will have to buy or sell shares to adjust the position. If the stock rallies to the strike of the call option, the delta will be very close to .50 and the market maker will need to buy another 25 shares to bring the total position delta back to zero.
If the stock continues to rally until the now in-the-money option has a 75 delta, the market maker would need to buy 25 more shares, and another 25 if the option’s delta went to 100. Notice that each buy came at a higher and higher price. That’s the curse of having a position with negative gamma – the readjustments to the hedge involve buying when the stock rallies and selling when the stock falls.
So which options have the most gamma? All else being equal, options with less time remaining to expiration have more gamma than options with relatively more time left. And options with a lower implied volatility have more gamma than options with higher IVs.
That may seem counterintuitive, but an simple example will clear it up. Many people use an option's delta as the percentage chance that that option will end up in-the-money at expiration. While that’s not precisely mathematically correct, it’s close enough for an intuitive understanding of gamma. If the at-the-money option has a 50/50 chance of winding up in the money, out-of-the money options must have a lower probability – as represented by a delta lower than 50.
If there’s a long time left until expiration (options are listed with two years or more until expiration), many options that are out-of-the money – but with strike prices that are relatively close to the current underlying price – will have a delta very close to 50 because there’s a close to 50/50 chance they’ll end up in-the-money. If the stock has years to move, many possible outcomes are likely.
If the stock rallies $5, that 25 delta option might change only to a 26 delta – it’s chances of ending up in-the-money two years from now haven’t materially changed - there’s too much time left for more stock movement in either direction to change the outcome.
Conversely, if an option is going to expire today, there’s not much time remaining for the underlying to move, so out-of-the-money options have a very small chance of ending up in-the-money and thus very small deltas. If the stock rallies $5 on the last day however, and goes through the strike of that (previously) 25-delta call, the new delta will be above 50 – perhaps 60, 80 or even 100. Gamma increases as expiration approaches.
The relationship between gamma and implied volatility works in a similar fashion. If a stock barely ever moves and the options are trading at a low implied vol, it’s relatively unlikely that out-of-the money options will wind up in-the-money, so they have low deltas. That means if the stock does make a move, the option deltas will change quickly. Those options have high gamma.
When a stock is trading at a high implied vol, the opposite is true. With the underlying moving all over the place, a great many outcomes are possible and – just as we saw with the long dated options – the deltas of out-of-the-money options move toward 50. Thus the change in delta as the underlying moves is fairly small; the options all stay near 50 delta.
Implied vol in the front few month of GameStop options has been incredibly high lately – between 300 and 800%. (Typically, options on broad indices trade with IVs in the high teens and individual stocks have IVs between 20% and 80%.)
Whether you’ve been aware of it or not, if you’re buying options as a way to make a leveraged bet on the direction of the underlying, you’d naturally prefer those with high-gamma. If you’re right about the move in the underlying, your option will change value in your favor very quickly. Also, at low implied vols, your long options will decay slower, losing less value simply because of the passage of time.
The traders who are buying high volatility options in GameStop are paying very high premiums, experiencing massive time decay and getting relatively low gamma. Buying calls has worked spectacularly well because of the huge moves the stock has made over the past few sessions.
The 115 strike calls that expire this Friday were heavily traded on Monday during a big rally. A trader might have paid about $60 each for them, which might have been as much as 800% vol depending on the stock price at the time of the trade. When the stock closed at $347.51 on Wednesday, those calls were worth $238 – a return of nearly 300% in just two days. That’s great and I take my hat off to anyone who had the fortitude to pluck down their money on those calls and hold them through a couple very wild trading sessions. Good for you!
If that’s not you however, I want you to carefully consider the value proposition associated with buying these enormously expensive options now. Acronyms like FOMO and YOLO have been thrown around on the message boards as a way of encouraging individuals to make big bets on GameStop – even when the odds aren’t great. There’s no doubt that the recent success (and enthusiasm) of those traders will lure more traders in search of outsized profits into the trade.
Buying GameStop options now is the equivalent of casino gambling. You might win, but the odds aren’t in your favor.
So what about selling those options?
If the odds aren’t in your favor when buying high vol options, they must be good if you’re the seller, right? It’s a zero-sum game, after all.
Yes, but you’ve got to be very careful here. To continue the casino analogy, individuals do win at casino games sometimes, otherwise no one would ever play them. It’s the number of transactions that the casino can make that ensures that the odds are skewed in their favor. If you have a small advantage (or “edge”) on a bet - like a coin flip that pays 55 cents on wins and charges 45 cents on losses – you want to make as many small bets as possible to let the odds average out in your favor.
If you were to bet your entire bankroll on a single toss, you’re more likely to win than lose, but there’s also a 50% chance you’ll be broke. Options trading is the same way. Those market makers we talked about earlier would always prefer to make a high number of small transactions – because the bid-ask spread provides them with an edge. The more transactions they make, they more likely it is that those small edges will add up to measurable profits.
Because GameStop options are so expensive, you probably won’t have the opportunity to make a lot of trades, and your results will be close to binary with good or bad luck being more responsible for the outcome than your skill in picking a good trade.
A trader who sold one of those 115 calls on Monday to collect that juicy $6,000 premium might have felt that the odds were on his side – and at the time I would have agreed with him!
Now he’s out almost 18 grand and unless he covered the trade for a big loss, he still has more upside risk.
So once again, if you’re tempted to wade into this crazy pool, I urge the most extreme caution imaginable. Even if you’re only trading one lots, you might find yourself in the deep end quickly. I’d recommend it only for the most experienced, confident and well-capitalized traders.
If you buy an option, assume that you might lose the entire premium almost instantly. If you’re a seller, be prepared to lose a big multiple of what you initially collected. If you think you know where the stock is headed, you’re safest using vertical spreads in which you buy and sell equal numbers of options, though that strategy precludes the sort of open-ended profit opportunities that seem to be drawing retail traders to GameStop options in the first place.
Above all else, no matter what you trade, I implore you to make sure that even in a truly worst-case scenario, you aren’t risking an amount of money that would jeopardize your lifestyle or your long-term investment goals.
You've got to live to trade another day...
-Dave
Want to apply this winning option strategy and others to your trading? Then be sure to check out our Zacks Options Trader service.
Interested in strategies with profit potential even in declining markets? Maybe our Short List Trader service is for you.
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A Deeper Look at GameStop Options
If you’ve been paying attention to the financial news this week, you have certainly seen the incredible rise of the shares of brick-and-mortar video game retailer GameStop (GME - Free Report) . You may have also heard that much of the price action in those shares is due to options trading rather than simply buying pressure in the shares themselves.
I scratched the surface of this phenomenon – often referred to as a “gamma squeeze” - on Tuesday for Zacks.com.
If you’re here reading the Know Your Options column, you’re probably interested in a more in-depth look at how gamma affects trading behavior as well as whether there are opportunities for individual investors in GameStop options.
Read on…
Delta is the sensitivity in an option’s price to a move in the underlying security. Gamma is the sensitivity of an option’s delta to a move in the underlying security - basically “how much will the delta change when the stock moves?”
Most individuals who are using options to speculate on the direction and magnitude of a move in the underlying or to generate income by selling options against their other holdings don’t pay much (if any) attention to gamma, but the professional market makers that are your likely counter-party on every trade pay very close attention.
There are thousands of stocks listed with tradable options. With many strikes and expiration cycles listed for each stock, there are tens of millions of contracts available for trading on any given day. In all but the most liquid and active short-term options, the bid-ask spread you see on the screen has been provided by a market maker.
In general, those market makers aren’t interested in taking a position on the direction of future moves in the underlying. Primarily, they want to collect that bid-ask spread. If the market for a call option is $4.80 bid at $5.00 offer and you buy one option for 5 bucks, the market maker who sold it to you doesn’t start hoping for the stock price to fall so that he can collect the entire premium you paid as the option expires worthless.
In fact, the best thing that can possibly happen to him is that someone else comes along immediately and sells him the same call option on the $4.80 bid. The market maker books a quick profit of 20 cents - $20 per contract for US equity options – and has no position (or risk) left on his books.
That tends to be unlikely however, so the market maker will likely hedge the trade against movement in the underlying buy buying shares to offset the delta of the short position. If the call option you bought had a .25 delta – meaning that its value will change by 25 cents if the underlying moves a dollar – the market maker will buy 25 shares of stock, making the total delta of his position zero. He is indifferent to small changes in the underlying price in either direction.
(I used “.25” to express the delta because delta is a percentage. From here however, I’m simply going to shorten it to “25” because that’s the way traders would describe it.)
Notice I said “small changes.” If the stock were to move a larger amount, the delta of the option changes and the market maker who wants to remain delta neutral will have to buy or sell shares to adjust the position. If the stock rallies to the strike of the call option, the delta will be very close to .50 and the market maker will need to buy another 25 shares to bring the total position delta back to zero.
If the stock continues to rally until the now in-the-money option has a 75 delta, the market maker would need to buy 25 more shares, and another 25 if the option’s delta went to 100. Notice that each buy came at a higher and higher price. That’s the curse of having a position with negative gamma – the readjustments to the hedge involve buying when the stock rallies and selling when the stock falls.
So which options have the most gamma? All else being equal, options with less time remaining to expiration have more gamma than options with relatively more time left. And options with a lower implied volatility have more gamma than options with higher IVs.
That may seem counterintuitive, but an simple example will clear it up. Many people use an option's delta as the percentage chance that that option will end up in-the-money at expiration. While that’s not precisely mathematically correct, it’s close enough for an intuitive understanding of gamma. If the at-the-money option has a 50/50 chance of winding up in the money, out-of-the money options must have a lower probability – as represented by a delta lower than 50.
If there’s a long time left until expiration (options are listed with two years or more until expiration), many options that are out-of-the money – but with strike prices that are relatively close to the current underlying price – will have a delta very close to 50 because there’s a close to 50/50 chance they’ll end up in-the-money. If the stock has years to move, many possible outcomes are likely.
If the stock rallies $5, that 25 delta option might change only to a 26 delta – it’s chances of ending up in-the-money two years from now haven’t materially changed - there’s too much time left for more stock movement in either direction to change the outcome.
Conversely, if an option is going to expire today, there’s not much time remaining for the underlying to move, so out-of-the-money options have a very small chance of ending up in-the-money and thus very small deltas. If the stock rallies $5 on the last day however, and goes through the strike of that (previously) 25-delta call, the new delta will be above 50 – perhaps 60, 80 or even 100. Gamma increases as expiration approaches.
The relationship between gamma and implied volatility works in a similar fashion. If a stock barely ever moves and the options are trading at a low implied vol, it’s relatively unlikely that out-of-the money options will wind up in-the-money, so they have low deltas. That means if the stock does make a move, the option deltas will change quickly. Those options have high gamma.
When a stock is trading at a high implied vol, the opposite is true. With the underlying moving all over the place, a great many outcomes are possible and – just as we saw with the long dated options – the deltas of out-of-the-money options move toward 50. Thus the change in delta as the underlying moves is fairly small; the options all stay near 50 delta.
Implied vol in the front few month of GameStop options has been incredibly high lately – between 300 and 800%. (Typically, options on broad indices trade with IVs in the high teens and individual stocks have IVs between 20% and 80%.)
Whether you’ve been aware of it or not, if you’re buying options as a way to make a leveraged bet on the direction of the underlying, you’d naturally prefer those with high-gamma. If you’re right about the move in the underlying, your option will change value in your favor very quickly. Also, at low implied vols, your long options will decay slower, losing less value simply because of the passage of time.
The traders who are buying high volatility options in GameStop are paying very high premiums, experiencing massive time decay and getting relatively low gamma. Buying calls has worked spectacularly well because of the huge moves the stock has made over the past few sessions.
The 115 strike calls that expire this Friday were heavily traded on Monday during a big rally. A trader might have paid about $60 each for them, which might have been as much as 800% vol depending on the stock price at the time of the trade. When the stock closed at $347.51 on Wednesday, those calls were worth $238 – a return of nearly 300% in just two days. That’s great and I take my hat off to anyone who had the fortitude to pluck down their money on those calls and hold them through a couple very wild trading sessions. Good for you!
If that’s not you however, I want you to carefully consider the value proposition associated with buying these enormously expensive options now. Acronyms like FOMO and YOLO have been thrown around on the message boards as a way of encouraging individuals to make big bets on GameStop – even when the odds aren’t great. There’s no doubt that the recent success (and enthusiasm) of those traders will lure more traders in search of outsized profits into the trade.
Buying GameStop options now is the equivalent of casino gambling. You might win, but the odds aren’t in your favor.
So what about selling those options?
If the odds aren’t in your favor when buying high vol options, they must be good if you’re the seller, right? It’s a zero-sum game, after all.
Yes, but you’ve got to be very careful here. To continue the casino analogy, individuals do win at casino games sometimes, otherwise no one would ever play them. It’s the number of transactions that the casino can make that ensures that the odds are skewed in their favor. If you have a small advantage (or “edge”) on a bet - like a coin flip that pays 55 cents on wins and charges 45 cents on losses – you want to make as many small bets as possible to let the odds average out in your favor.
If you were to bet your entire bankroll on a single toss, you’re more likely to win than lose, but there’s also a 50% chance you’ll be broke. Options trading is the same way. Those market makers we talked about earlier would always prefer to make a high number of small transactions – because the bid-ask spread provides them with an edge. The more transactions they make, they more likely it is that those small edges will add up to measurable profits.
Because GameStop options are so expensive, you probably won’t have the opportunity to make a lot of trades, and your results will be close to binary with good or bad luck being more responsible for the outcome than your skill in picking a good trade.
A trader who sold one of those 115 calls on Monday to collect that juicy $6,000 premium might have felt that the odds were on his side – and at the time I would have agreed with him!
Now he’s out almost 18 grand and unless he covered the trade for a big loss, he still has more upside risk.
So once again, if you’re tempted to wade into this crazy pool, I urge the most extreme caution imaginable. Even if you’re only trading one lots, you might find yourself in the deep end quickly. I’d recommend it only for the most experienced, confident and well-capitalized traders.
If you buy an option, assume that you might lose the entire premium almost instantly. If you’re a seller, be prepared to lose a big multiple of what you initially collected. If you think you know where the stock is headed, you’re safest using vertical spreads in which you buy and sell equal numbers of options, though that strategy precludes the sort of open-ended profit opportunities that seem to be drawing retail traders to GameStop options in the first place.
Above all else, no matter what you trade, I implore you to make sure that even in a truly worst-case scenario, you aren’t risking an amount of money that would jeopardize your lifestyle or your long-term investment goals.
You've got to live to trade another day...
-Dave
Want to apply this winning option strategy and others to your trading? Then be sure to check out our Zacks Options Trader service.
Interested in strategies with profit potential even in declining markets? Maybe our Short List Trader service is for you.