The Bucking Gamma Bull—long-time subscribers to Calendar Options and Condor Options know it well. But we have a lot of new members this month, so let’s review what the phrase (coined by Jared) means and why it’s important to net option-sellers like us.
“Gamma” is the rate of change in delta with respect to underlying price. If delta is constant, gamma is zero, in which case your P/L curve would be a straight line (stocks are the easiest example to visualize—delta is +1 at all times and prices). Our positions, by contrast, have negative gamma (delta increases as the underlying price falls and decreases as the underlying rises). This is what gives our typical risk profile that familiar concave shape.
What’s also typical of our portfolio is for gamma to increase the closer we get to expiration. The most dramatic example is a single-strike calendar spread:
The white line in the figure above is the risk profile today for this November/December calendar spread; the red line projects the P/L curve out three weeks from now. The steeper the cone shape, the more gamma—which means greater risk. For more about gamma and its effects during expiration week, you can read Jared’s excellent series on the subject: The Bucking Gamma Bull, Holding Options to Expiration and On Gamma and Holding Positions Through Expiration.
So what does all this have to do with this week’s status update? Besides the fact that, as an experienced full-time trader, I sometimes do hold quite a few positions through expiration and was busy at the gamma rodeo last week,…risk management.
Profit vs. Risk (and Peace of Mind)
When Tuesday’s trade notice went out around 3:00pm Eastern, our October portfolio was showing a Model Portfolio return close to 4% for the month. And while not all that dangerous with SPY priced in the vicinity of $123, portfolio gamma would have increased rapidly if the rally were to have taken off the next day. Calendar Options veterans know that there have been times when we’ve held some positions right through expiration week (and even through expiration)—but this isn’t a a day-trading strategy, so we officially took the conservative route for new members, letting more experienced members make up their own minds whether the potential reward of holding longer was worth the risk (and possible sleepless nights).
The answer, as it turned out, was…well, maybe. Because the market went haywire shortly after I posted last Tuesday’s trade notice, we were…ahem…slammed on execution. Front-month volatility spiked, and schizophrenic price swings made it extremely difficult to get optimal pricing on our last two orders (which had opposite delta). A very astute and nimble trader could’ve done a little better, but trying to be that nimble via e-mail alerts isn’t exactly the best recipe for sanity. And, of course, hindsight is always 20/20.
Adding It Up
Considering the overall risk we took on for the month, though, we still did pretty well in an extremely volatile, news-driven market. Net realized gain depends a lot on how much you’re paying for commissions, which is why we leave that variable out of our performance calculations. (While we’re on the subject, no one should have to shell out more than the equivalent of $1.00 per contract, and $0.65–$0.75/contract isn’t unheard of, if you’re willing to shop around and negotiate.) Even after deducting $1/contract per trade, we achieved a return of about 1% (more than 12% annualized)—but here are the official numbers, before commissions, for comparison with our historical performance:
Average return per trade was 5.82%—well above our long-term trend line. Because we risked a smaller-than-usual portion of the capital allocated to our Model Portfolio, over a relatively short period of time, Model Portfolio return was “only” about 1.9%…which annualized comes to a “mere” 25%. There are dozens of newsletters out there trumpeting absurd gains (“We made 13,000% on just one trade!”), but what they don’t tell you is that very few of their trades are home runs, and many are big losers. When normalized for risk, 20% is about the best annualized return on investment one can realistically hope to achieve on a consistent basis. Just look at how much better we’ve done recently than many high-profile investment firms like, say, Blackstone (for just one example).
Our philosophy is that helping members learn to be better options traders, without incurring huge losses in the process, is much more important than spectacular performance claims (which invariably turn out to be bogus when subjected to even the slightest scrutiny). As the Chinese proverb says, “Give a man a fish and you feed him for a day. Teach a man to fish and you feed him for a lifetime.” And the way we fish is by slowly and consistently trawling our nets, not by throwing sticks of dynamite in the water hoping that five tons of Chilean Sea Bass will float up once in a while.
So what are the key lessons for calendar traders from the October cycle?
- Risk less capital in volatile markets;
- Hedge conservatively when uncertainty is unusually high, even if it reduces potential profit;
- Lock in returns when gamma reaches the point that all your profit could disappear overnight;
- Changes in implied volatility (especially volatility term structure) can have a huge impact on calendar-spread P&L, especially in expiration week;
- Execution can be as important as choosing the right trades;
And, perhaps most important, given a strategy that’s proven profitable over the long-run,
- Trade consistently and with discipline – A trader who strays from the rules of a winning strategy, or doesn’t implement that strategy every month, month after month—especially after a losing month or quarter—will not achieve the long-term results that the strategy delivers.
On that last note, we’re planning to open our first position for November expiration as soon as tomorrow morning, conditions permitting.