Gamma Risk III

As time goes forward and if the SPY doesn’t move the gamma of that calendar spread will go from –40 to – 175 in the last few days before January expiration. That means that the delta can have about a -140 to +180 range if the SPY moves 1.00. That much short gamma means that the position is manufacturing the “bad” deltas very quickly. But two weeks before January expiration, the gamma is short -90, which is about half of what it will be a week later. Because the short gamma basically doubles in that week, it is suggested that you look to either roll the short option of that calendar spread or close the calendar entirely beginning about 1.5 weeks before expiration. The theta also increases dramatically in that week, but the position becomes unstable, too, which is indicated by the growing short gamma. And the whole reason for having the short gamma that can manufacture the "bad" delta is all that positive time decay. The time decay is the reward for taking the risk of the short gamma. Now if you want to hedge your delta risk, you can trade stocks or options. But if you want to hedge gamma, you have to use options because stock has zero gamma. The short gamma of that SPY calendar spread is concentrated in the short front month option. Remember that its gamma is high because it’s at the money and close to expiration. You can eliminate the close to expiration aspect by buying it back and selling the next month’s option. That, along with collecting a credit, is one of the points of rolling. This is a very simple example of how to interpret the gamma of a calendar spread, but you can extend this to any position. You have to develop a sense of how much gamma is too big for your account. The way to do that is to translate that gamma into potential delta. Delta is a much easier number to interpret, and it’s more intuitive to understand that 500 deltas of SPY has more directional risk than 100 deltas of SPY. You can then use gamma to see how much your delta might change. If the gamma can drive your delta to a point that you feel you have too much directional risk, then you should reduce the gamma either by rolling the short options or buying them back. When you have positive time decay, you will have negative gamma. That negative gamma can present problems, but you shouldn’t fear it. As long as you understand the impact it has on your position, you can manage it.