It might sound odd to compare a childhood game with understanding how to trade low volatility – but hear me out. I played a game called pickle with my friends on a baseball field growing up. The goal is to run back and forth between two bases without getting tagged out. There is a lot of dodging, ducking and swerving involved, as it’s a thrilling zero sum game often filled with surprising moves.
Sounds an awful lot like options trading, doesn’t it? Some of the best options trading strategies are similar to the strategies my friends and I used when playing pickle: Do your best to stay away from the tag that puts you out of the game.
Of course, some strategies are riskier than others. Take the short gamma trade, which has been a winner mostly due to extended low volatility (more on that in a bit). A better bet is using a high probability approach with low risk. It offers a chance to not only stay in the game but to win far more often, even if the rewards are small.
And that brings us to how to trade low volatility, which is currently plaguing the markets. Low volatility means little movement on some days, making trading very difficult. Now, that doesn’t mean stocks won’t move, it simply means the market as a whole has low probability of big moves (note I said probability, not certainty!). It’s almost as if the players on the other pickle team are just standing there holding the ball while you run back and forth. You never know when the ball is going to get thrown – and that’s unnerving.
As an options trader, I need to be aware of what will drive prices in certain conditions (aka, what will cause the ball to get thrown). This is when I turn to “the Greeks.” Let’s look at two of them: delta and gamma.
How to use delta and gamma to trade low volatility
Delta is the amount an option will move with a $1 move in the underlying asset (in most cases, a stock). The delta moves constantly with time and the price of the underlying. Gamma is derived from delta. It’s the rate of change the delta will move and is either positive or zero. The key here is to identify a strong rate of change up or down in gamma, depending on our position.
If the gamma is retreating, it means the amount delta will move is also shrinking, a delight for those who are short options. Conversely, long option holders despise the shrinking gamma, which is a solid bet when volatility is low or declining.
Some traders actually make a living selling deltas and shorting gamma. While the current condition seems ripe for that strategy, it’s not always a safe bet. In part 2 next week, I’ll explore the mechanics of this strategy, review a real-life trade and explain how I saved the trade by using technicals and charts.