In my last blog post, I compared options trading to playing pickle, a childhood game. Just like when trading options, your goal playing pickle is to not get tagged out. In other words, you want to increase your probability of winning while lowering your risk as much as possible. Simple in theory, difficult in real life!
That’s where delta and gamma come into play. By using “the greeks,” we can be even more precise with probabilities by narrowing our timeline. This comes in very handy when volatility is low.
If you’re not familiar with the greeks, delta is the change in the option price with a $1 move in the stock, while gamma is the rate of change in the delta (a derivative). It is extremely helpful to know how fast or slow the delta is likely to move, because a slower (or lower) gamma is a huge advantage to the premium seller.
How to use delta and gamma
If you are short options (delta), you want to see that rate of change slow down, aka have the gamma head toward zero. This is an ideal scenario when volatility is low and not moving up or down. If you are short put spreads, for instance, that falling gamma means the option prices are falling. If you were paid a credit, you want to see the options expire worthless to keep the entire credit.
If you are long options (delta), you want to see that gamma expand, giving your options a great chance to overcome time decay. This is an ideal environment when volatility is rising.
An options trading example: RUT
When volatility is low, the market expects very little movement, which means you have to accept smaller rewards when selling premium. But it can still work to your advantage. My colleague Suz Smith, who runs Spread Trader, has pulled off many of these trades this year with mastery and precision.
In one recent trade, she sold RUT (Russell 2K Index) bull put spreads with strikes at an area that were deemed “safe.” Spreads deliver less return but define our risk to the size of the spread only. If something really bad occurs, we won’t be wiped out. There is no guarantee, but the probabilities are high enough that winning is in our favor for the amount of time remaining.
On May 31, the markets swooned down hard and bounced back. Before that bounce, Suz was looking at the 1320/1300 bull put spread (sell 1320, buy 1300) for the June monthly expiration – just over two weeks out. At one point during the day, the RUT was down to about 1355, penetrating the lower bollinger band. This is a low risk entry point and therefore a good place to open this type of trade. You collect 2.30 for the spread and then just wait it out for 12 trading days.
At expiration, the RUT was at 1400, nowhere close to the short strike of 1320. As a result, we kept the entire credit of 2.30 when the contracts expired worthless on June 16. Selling ten spreads would have resulted in a cool profit of $2,300 for the 12-day period, a very nice annualized return. Fortunately, this trade went smoothly and Suz didn’t break a sweat, but it’s not always like that.
The very low delta (about 12% at the time) and low gamma were enough to convince Suz that this trade had an excellent chance of working. Simply put, an 88% chance of success was built in at the time the trade was established. Suz picked strikes that would be far enough away from trouble but with the understanding the heat could be turned up at anytime.
Repeated over and over again this strategy can be an enormous boost to your portfolio. Start using delta and gamma while volatility is low and experience the thrill of winning at high probability, low risk trades.
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