How Gamma-Neutral Strategies Work

Summary:

Gamma neutral is a technique that helps investors cushion themselves against changes and fluctuations in the price of options owing to movements in the underlying stock. This blog should make it easy for you to implement a gamma-neutral strategy to help protect your investments and maximise returns.

Introduction to gamma-neutral trading

Gamma neutral is a technique that is used to build a portfolio of investments where the delta fluctuation rate is zero. In option trading, it is a very important variable that helps investors cushion themselves against changes and fluctuations in the prices of options triggered by the movements in the underlying stock. In options trading, the Greek alphabets Gamma, Delta, Theta and Reo are the variables that are used as risk determinators.

Gamma, like the rest of the risk indicators, is used to minimise and mitigate the effects of changes in options prices due to fluctuations in the underlying assets.

Devising a gamma-neutral strategy

Like most other strategies, the intention of this strategy is also to earn faster and greater returns from the investment. Here, the goal is to achieve a zero value for gamma or get closest to zero. Movements in the underlying stocks are very common and this strategy can be used to ensure that the value of Delta remains stable, irrespective of the movement in the underlying assets.

How to implement a gamma-neutral strategy

Given that gamma calculates the rate of change of the delta (sensitivity of the price of the option to movements in the price of the underlying asset), a strategy that is gamma-neutral will try to generate profits that arise from fluctuations in the price of the underlying asset, while mitigating the effects of volatility.

The following steps can help to implement a gamma-neutral strategy:

• Choose the underlying asset: First, you must select the security or underlying asset on which you want to apply this strategy. This could be an ETF, a stock, an index, or any other financial instrument.
• Decide on the market outlook: Determining your market outlook requires understanding if you expect the underlying asset to be stable, go up, or decline. This will help to decide on selecting option positions.
• Select option positions: Based on the market outlook, you will need to use short and long positions in combination. To achieve a gamma-neutral position, iron condor, strangle and straddle are some of the commonly implemented option strategies. A bullish/bearish position will warrant a long call/put. A bearish/bullish position will warrant a short call/put. Use a combination of both to manage your exposure to delta and gamma.
• Calculate gamma: In this step, you will need to calculate the value of gamma for your option positions. To achieve a gamma-neutral position, the short and long positions will need to cancel each other with regard to gamma.
• Position adjustment: With movements in the price of the underlying assets, the position of the option will need to be adjusted to make sure that the value of gamma is close to zero. If the value of gamma is positive, it means that there is a net long gamma exposure. This implies that you will need to buy or sell options to bring about a balance.
• Continuous monitoring: Once you have set your positions, make sure to consistently follow the market and your portfolio, and ensure your position is holding ground. If you find that there are more changes taking place in the prices of underlying assets, make further adjustments to ensure that your strategy remains gamma-neutral.
• Profit taking: Whenever you see that the underlying asset’s prices are meeting your expectations, be prepared to take profits. This is because strategies that are gamma-neutral tend to be very capital-intensive and require gains to be realised whenever possible.

The benefits of using a gamma-neutral strategy

• By ensuring that the positions of short and long options are balanced, investors can minimise their directional risk. This proves to be very helpful when investors are keen on making profits from fluctuations due to volatility, instead of just price changes.
• Volatility may not always be a bad thing. A gamma-neutral strategy can help reposition a portfolio irrespective of whether the prices move upwards or downwards.
• In contrast to options strategies that are purely directional, a gamma-neutral approach is less sensitive to time decay.
• Strategies that are gamma-neutral can be used for portfolio hedging to ensure market volatility has a limited impact on the portfolio and returns.
• Gamma-neutral approaches can be used to varying market conditions to help mitigate risks that arise out of fluctuations.

Summing up

Though gamma-neutral strategies have their benefits, they do have their risks and disadvantages as well. With a little research and help, you should be able to implement a gamma-neutral strategy to reduce the exposure of your portfolio to market volatility.