Gamma Scalping
Intraday trading is seldom entirely in one direction. A stock may close
higher or lower, even sharply higher or lower, on the day, but during the day
there is usually not a steady incremental rise or fall in the stock price. A
typical intraday stock chart has peaks and troughs all day long. Delta-
neutral traders who have gamma don’t remain delta neutral as the
underlying price changes, which inevitably it will. Delta-neutral trading is
kind of a misnomer.
In fact, it is gamma trading in which delta-neutral traders engage. For
long-gamma traders, the position delta gets more positive as the underlying
moves higher and more negative as the underlying moves lower. An upward
move in the underlying increases positive deltas, resulting in exponentially
increasing profits. But if the underlying price begins to retrace downward,
the gain from deltas can be erased as quickly as it was racked up.
To lock in delta gains, a trader can adjust the position to delta neutral
again by selling short stock to cover long deltas. If the stock price declines
after this adjustment, losses are curtailed thanks to the short stock. In fact,
the delta will become negative as the underlying price falls, leading to
growing profits. To lock in profits again, the trader buys stock to cover
short deltas to once again become delta neutral.
The net effect is a stock scalp. Positive gamma causes the delta-neutral
trader to sell stock when the price rises and buy when the stock falls. This
adds up to a true, realized profit. So positive gamma is a money-making
machine, right? Not so fast. As in any business, the profits must be great
enough to cover expenses. Theta is the daily cost of running this gamma-
scalping business.
For example, a trader, Harry, notices that the intraday price swings in a
particular stock have been increasing. He takes a bullish position in realized
volatility by buying 20 off the 40-strike calls, which have a 50 delta, and
selling stock on a delta-neutral ratio.
Buy 20 40-strike calls (50 delta) (long 1,000 deltas)
Short 1,000 shares at $40 (short 1,000 deltas)