Thursday, May 20, 2010

Public Enemy #1

In Tuesday's ratios post, I mentioned the struggle between Gamma and Theta that builds into expiration. The events of the past few days illustrate well the perils of holding short gamma positions too long. This is an instance where the extra rope lent to the ratio spread definitely turned into a noose. It also shows why Gamma is an option sellers most treacherous foe.

But hey such is life for a trader selling short term options. Look, you want quick rates of time decay, fine. But for as many times as you get to enjoy the additional and oft times quick profits you rake in from riding to expiration, you're going to have to inevitably deal with the occasional horror show where the market makes a kamikaze run for your short options. In the long run, the extra few bucks accumulated from riding to expiration unscathed typically pale in comparison to what's forked out to pay the piper when those short options come back to bite ya.

It's the tale of two expiration's. Sometimes options go out like a lamb, sometimes they go out like a lion.

So how do option sellers protect themselves from public enemy #1? It's simple really. They steer clear of short term options. This is why you find traders who sell two or three month iron condors or strangles as opposed to front month. They've opted to forego the alluring high rate of time decay offered by short term options for the lower gamma risk of longer term options. In addition they may avoid holding short options too close to expiration by closing them one or two weeks prior.

For related posts readers can check out:
Gamma Facts

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