Often, when I ask; "What is the best position for a market maker to have?" (I am looking for the answer; "a flat position") students say, "Long gamma." It is true that a long gamma position creates deltas favorable to the market direction. That is a wonderful thing to have happen, but remember that there is a luxury tax attached to this position and can be very costly. The exposure is negative theta, which means that your asset is wasting away and is also subject to potentially devastating decreases in implied volatility. Gamma scalping methods can be used to recapture some or all of the lost premium, but it is more of a defensive play (money saver) than a money maker.
Gamma scalping is basically fading the market as the position manufactures deltas. Gamma scalping is not for everyone, but the following discussion will surely tie up a lot of loose ends regarding options behavior. The gamma scalping type of neutralization, also referred to as "delta hedging", is performed on an as needed basis by market makers whether it be from the long side or short side. The following experience will illustrate the strategy.
Story: Scalping Gammas in My Sleep: One afternoon I left the exchange with a net exposure equivalent to 110 at-the-money (3800) straddles in the CME Swiss Francs. Although I had a position consisting of thousands of contracts, after dissecting the position, I was net long the same number of gamma as 110*3800 straddles would have been. I simply took the net gamma of my total position and divided into that figure the gamma for one 3800 straddle. The product was my net at-the-money straddle equivalent. The net at-the-money straddle equivalent is the amount to liquidate when you want to take a break from trading or want to flatten out your exposure. Since the at-the-money straddle options are usually the most liquid, it is generally easy to get a fair price. In my case I would have had to sell 220 of the 3800 options against futures to neutralize the position. That night there was a Group of Five Nations meeting, and some news that could move the market was expected, so I decided to speculate for a big move and an increase in implied volatility.
Each at-the-money straddle settled at 222 ticks ($2,775.00) at the close for a total cost of $305,250.00. I had no intention of risking even 5% of that figure. My maximum risk as far as I was concerned was going to be $10,000.00 (about 7 ticks per straddle). My only concern was my cost, 222 ticks. I hoped to reduce that cost by making a small profit through gamma scalping opportunities.
Positive gamma scalping can take place when a position is long premium and negative gamma scalping can be carried out when a position is short premium. My total gamma was 3054 @ SF3790 for a one point move. Notice that if the market had rallied about a point to 3890, the delta would become long 2978 deltas (or 30 futures worth). About a point lower down at 3690 we would have been short 3019 (or 30 futures worth). See Exhibit 4-5.
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