By John Netto of One Shot – One Kill Trading*
Posted: Dec 19, 2008

The recent spate of volatility has forced traders to reassess their strategies from soup to nuts. Everything from position size, to duration of holding, stop losses and correlation coefficients has come under greater intense examination because the various asset classes of the trading world are more inextricably linked than ever before.

Because of these conditions, a strategy that has taken on more of a prominent role in my portfolio management style is gamma trading. I define gamma trading as using options to take on a particular view point in the market, while using the underlying to dynamically adjust my exposure, according to my evolving viewpoint.

I am the Chief Investment Strategist for a hedge fund that focuses on currency trading and that takes on exposure at major inflection points in the market. As such, one of the areas I have to be cognizant of is the tussle that goes on between the bulls and the bears at these key levels.

Using the gamma trading strategy I am about to explain, you will be able to see how this tussle creates some opportunity to reduce one's cost basis for a particular trade and work around a position more dynamically. This is made possible due to proper structuring when you are setting up an options trade on a position.

The goal of this article and the Part 2 article is to illustrate both long and short gamma trading strategies. Because both have a myriad of potential benefits and drawbacks, these articles will walk you through the first steps of actively incorporating these strategies into your portfolio management protocol.

The Part 1 article covers the metrics of long gamma trades that associate an expense, or debit, with an account. The second article will cover income-generating strategies that incur a credit to the account. Part 2 will appear later in eSignal’s Weekly Trading Education article series and serves as a key supplement to this article.

These 2 articles assume that you already have a basic understanding of the Greeks that associate with option pricing. A number of online sites have this information. It is important knowledge to have before launching into the topic of gamma trading options, so I spend a good percentage of the early portion of the classes I teach going over the basics of options trading.

My first example using this scenario is a short position I took on in a USDJPY currency pair (or long the yen futures on the CME). I put this trade on in the middle part of June as the weekly chart of the cross was reaching a luscious inflection point, thereby necessitating a position that would create some nice short exposure.

Instead of just going long the yen futures and hoping for the best, I initiated a fence strategy, also known as a married put or collar position. This strategy involves going long the underlying yen futures, buying an at-the-money put and selling an out-of-the-money call to offset the price of the insurance, at the cost of some potential upside.

The process of picking spots to take on a bullish or bearish position is not the main focus of this article per se. However, executing this through a gamma trading strategy enhances the flexibility that one can employ when managing this position. I put nearly all of my trades for this strategy on through the futures (yen September contract) because, in my experience, the options on the CME FX futures have been more liquid and tightly priced than what I have seen from any comparable Forex platform.

With the yen futures trading at 9310 (USDJPY at 10800), I went long the underlying September contract. I simultaneously purchased a September 9300 put and sold a 10000 September call. The two options expired on September 5, or approximately 80 days later, and incurred a debit to the account of 130 ticks. (September puts cost 194 ticks. September calls were sold for 64 ticks, thereby leaving a debit of 130 ticks.)

My break-even point on the trade was at 9440, and my max upside was for the yen to return to parity with the dollar at 10000. With each tick on the yen worth $12.50, I was risking a total of 140 ticks (130 from the debit and 10 from the underlying because I entered at 9310), or $1,750 per contract, with a max upside of $7,000 per contract if the reversal that I saw happening over the next 80 days took place.

By doing this, I have managed to accomplish a few things. The first is taking on a bullish yen position, and the second is clearly defining my risk. The pricing of this appears in the exact same manner as a 9300/10000 call spread. As a matter of habit, I like watching the profit and loss of the underlying position because it better helps me internalize market price action. However, no mathematical advantage is gained as a result of setting up the trade this way.

I have now put myself in the market so that I can begin to trade around a core position at key spots, offsetting some yen exposure at key inflection points. The value on this trade was from a weekly time horizon, which doesn’t preclude the underlying daily uptrend on USDJPY from providing spots to hedge out. This is advisable because I am in a de facto short position of that cross as a result of being long the yen futures.

In the event that I do offset some exposure, and the yen starts to rally hard, I won’t be hurt because the upward explosion of the position and increase in gamma will more than offset the bullets that I have fired when trying to trade around my core. This is one of the key concepts to grasp when understanding gamma trading of FX options.

Because I put on a 10 lot, I will be trading 1 to 3 contracts at most key spots on the charts where I think the yen can come under pressure and sell down. I will be more liberal with some special situations, letting me sell as many as 5 contracts. This allows some maneuverability by reducing my exposure to the underlying when I hit critical spots, much like taking profits if I were just trading the underlying with no options at all.

This is important because I was going long the yen on a weekly chart, yet the daily was still bearish. Near most of these major tops, there is typically going to be a lot of give and take in terms of price action. Having a strategy that lets you grab some of that push and pull puts another tool in your arsenal of trading weapons.

Using a flexible strategy to trade around a core position can help offset the inherent time decay of long gamma strategies, as well as serve as a backstop -- in case you’re wrong when attempting to adjust your exposure dynamically. This is why gamma trading is ideally done with your initial position containing multiple options contracts (at least 4, but preferably 10 or more).

The time decay in this position, as with all options positions, increases exponentially as you approach expiration. For the month of June, I was staring at time decay in the area of $25 a day per contract. (September 9300 puts were losing approximately $30 a day, and September 10000 calls were making us approximately $5 a day per contract.)

I put the position on for a 10 lot, so $250 a day was the vig (i.e., commission). If all other things stayed equal (specifically, the price of the underlying and implied volatility), I would have to make $250 a day by trading around the position to offset this deterioration.

Gamma trading allows a trader to materially alter the risk-reward profile of a trade in ways that, if he or she were trading the underlying exclusively, would not offer such choices.

As a hedge fund manager, I know my job is to deliver the best risk-adjusted return possible. A common misconception not openly discussed in mainstream media is that, when many institutions look to allocate capital, they are more concerned with the drawdown and risk management capability of the underlying manager, rather than the outright return.

This has helped studies such as the Sharpe and Sortino ratios become an important financial tool because they do a better job of analyzing the skill set of a manager than just an arbitrary return.

The aforementioned strategy is a long gamma strategy. The more the yen futures rise, the more exposure I have to the upside on the yen, up to 10000. From there, my profit is capped; it stands on a closing basis.

However, it is still in my interest to see the yen rally because the value of the spread itself will continue to gain value, up to the $7,000-a-contract price cap. While I rarely ever hold such a position until expiration, it is the flexibility and adaptability I have to offset risk at key spots that keeps me going back to these trades.

After I put the trade on in mid-June, the USDJPY went on a nice sell-down, which materially benefited the position. However, the move down to 10500 was a nice spot on the daily charts for those waiting for a chance to step in and go long.

Although I wasn't looking to play the upside so aggressively, I was cognizant of the potential for an impending bounce. As such, this was a great spot to reduce my long yen gamma by shorting some yen futures contracts at what was equivalent to the 10525 level.

A few benefits derive from exiting at this level. The first is that, being at such a strong daily technical support level, I am dynamically adjusting my exposure, keeping myself poised to take advantage of a bounce and reducing my cost basis in the trade.

The second advantage is that, if the yen does turn around and rally, and I opt to close out the position, the realized profit on 4 of 10 contracts I covered will more than offset any time decay that would have happened over the course of the few weeks I held the position.

If I was just long the underlying, many of these choices would be limited. I can also keep part of a core position of yen long at these levels so that, if things do keep going in my favor, my gamma will begin to rise slowly. However, because I was short the 10000 calls, I effectively went to delta neutral by offsetting such a heavy portion of my core in this spot.

What's so appealing about using FX options in a volatile currency market is the compartmentalized risk management that is taking place. Should the yen keep rallying, I can feel comfortable buying the next dip, with any hope, at approximately the same spot we had just covered near the 10500 level.

As it turned out in this case, the USDJPY did, in fact, rally back near the .618 Fibonacci retracement only a few days later. This provided a great opportunity to re-enter my full position at 10700, or gain approximately 175 pips on 40 percent of the position in a matter of a week.

Had we held the core position the entire way, factoring in time decay, we would have seen only incremental gains in the position as a whole. However, because we actively managed the trade using a sound technical strategy, and had a feel for the underlying sentiment of the market, we were able to reduce our cost basis, lock in profits and / or deliver a better risk-adjusted return.

Much to the fund's pleasure, the USDJPY spun down off this level and, by the middle of July, had worked down to a nice 1 x 1 measured move on the daily chart. I used the retest of 10500 to cover some yen exposure. I also used the 10427 level to blow out some more yen and go back to practically delta neutral.

This turned out to be a good move because the subsequent weeks saw the USDJPY gain traction and head back to the 10800 level. I am not a particularly big believer in triple tops, so I closed out of the position in the following weeks.

Although this wasn't the ceremonious ending I was looking for, the position management did allow me to do fairly well from the position that ultimately ended up testing the 11000 level as the dollar spent August crushing a number of the major currency pairs and commodities it trades against.

The aforementioned trade example was just one way of using CME FX options to create synthetic exposure to the market. There are numerous possibilities for using long gamma strategies. However, I have found the art of execution something one becomes better at over time and with application.

Part 2 of gamma trading options will walk us through how short gamma trading strategies serve a number of functions and trading utility. We will discuss the pros and cons of these actions and how this strategy fits into our overall strategy.

*Reprinted (and modified) with permission from John Netto of One Shot – One Kill Trading (www.osoktrading.com). His book is One Shot – One Kill Trading, McGraw-Hill 2004. You can email John at: jnetto@osoktrading.com.