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Confused About the Direction of the Markets? You Might Want to Own Gamma

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We’ve certainly seem some wild moves in the markets recently and it certainly be reasonable for an average trader or investor to be confused about the likely direction of stock prices in the near term.

The major averages are clinging to small gains of 1-2% for the year, but they’ve experienced a lot of volatility to get here. The buy-and-hold strategy that has worked so well over the past decade has produced only modest returns lately – and it has been far from stress free.

A strategy to earn additional returns in the options markets during periods of exaggerated news is to own “gamma.” You’ll recall from our discussion of options greeks that delta is the price sensitivity of an option to a move in the underlying and that gamma is the delta sensitivity of an option to a move in the underlying – how much the delta changes when the stock goes up or down.

If you own an option you are long gamma. If you purchase a 50 delta call and the stock rises, the delta of the call increases, making you longer the underlying. If the stock declines, the delta of the option decreases, making you less long the underlying. Just like calls owning puts also makes you long gamma, though obviously the delta works in the opposite direction.

Having a position that increases or decreases exposure to the underlying in the direction that the stock is moving is obviously advantageous, but it comes at a price – time decay. If you own options and the underlying is not moving, they lose a portion of their value as time passes. That time “decay” accelerates as expiration approaches and an option that’s about to expire out-of-money becomes worthless.

In periods like these when the market is not showing a clear directional trend and the effect of news stories and other events cause large moves, owning gamma can be profitable.

The Strangle

If you were to purchase a 2% strangle on (SPY - Free Report) (the S&P 500 Index tracking ETF) – buying one call and one put that are both currently about 2% out of the money – you’d be long gamma. When the index rises, the delta of the call rises and the delta of the put falls, making your exposure to the market longer.

When the index falls, the opposite happens and you are shorter the market.

In the options that expire on January 19th, the total cost of buying the 261 strike put and the 273 strike call would be approximately $7.25. That’s the most you stand to lose on the trade if both options expire worthless.

A conventional options p/l diagram for the trade would look like this:

It shows that you stand to make unlimited profits in either direction if the SPY moves significantly and profits on the trade start if SPY moves outside the strikes by more than $7.25/share, but that’s only if you hold the trade to expiration.

If the market moves up and down frequently between now and expiration, you can still make money on the trade even if it doesn’t finish below $253.75 or above $280.25.

If you wake up one morning and a particularly positive of negative development has occurred that’s causing the market to rise or fall quickly, one of your options will appreciate much more quickly than the other depreciates because of the effect of gamma.

Let’s look at a big down move first.

If the S&P 500 opened down 2% tomorrow, $259/share at the time of this writing, the 261 put would be likely be worth somewhere around $8. You’d have a few choices. You could hold the trade to see if it continues to go your way, or sell the put for a profit and continue to hold the 273 call which will appreciate if the market rallies,

Or you could buy stock at $259/share. That would lock in $2 of profit, bring your cost basis on the trade down to $5.25, while preserving more upside potential.

If the SPY were to subsequently rally back to $267/share by expiration, you’d sell the 100 shares you bought at an $8 profit, the options would expire worthless and you’d have a modest $0.75 profit on the entire trade.

If, however SPY rallied all the way to $280/share – which is only 8% off the lows and less than 5% above the $267 level where you initiated the trade, you’d have 200 shares to sell (the 100 you bought, plus 100 from the 273 call) and a profit of $20.25.

Basically, owing the strangle and the gamma allow you to buy shares on declines and sell them on rallies while still knowing what your absolute worst-case scenario risk is.

In choppy markets, that’s a good position to be in.

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