Smileys and Frowns
The trade examples in this chapter have all involved just two components:
calls and stock. We will explore delta-neutral strategies in other chapters
that involve more moving parts. Regardless of the specific makeup of the
position, the P&(L) of each individual leg is not of concern. It is the
profitability of the position as a whole that matters. For example, after a
volatile move in a stock occurs, a positive-gamma trader like Harry doesn’t
care whether the calls or the stock made the profit on the move. The trader
would monitor the net delta that was produced—positive or negative—and
cover accordingly. The process is the same for a negative-gamma trader. In
either case, it is gamma and delta that need to be monitored closely.
Gamma can make or break a trade. P&(L) diagrams are helpful tools that
offer a visual representation of the effect of gamma on a position. Many
option-trading software applications offer P&(L) graphing applications to
study the payoff of a position with the days to expiration as an adjustable
variable to study the same trade over time.
P&(L) diagrams for these delta-neutral positions before the options’
expiration generally take one of two shapes: a smiley or a frown. The shape
of the graph depends on whether the position gamma is positive or negative.
Exhibit 13.3 shows a typical positive-gamma trade.