Vertical Spreads II - Market Analysis for Nov 28th, 2016

The gamma switch
No matter what kind of gamma we have picked for our vertical spread at inception (long or short) it will switch signs eventually. The rule is a very simple:

- A long gamma vertical spread will switch to short gamma only when the underlying moves in the direction of the trade.
- A short gamma spread will switch to long gamma only when the underlying moves against the trade.
- For anything else the sign of gamma will remain constant

What the rules mean in plain English is that a long gamma spread will make money when the underlying moves in the desired direction, but after some point the profit will be less and less and then it will be capped to the max profit (gamma will become negative and delta will become 0 at some point).

For a short gamma spread, then the opposite is true, if the underlying moves against it, then the loss will increase rapidly and after a while it will be capped to the max loss.

Implementing a desired gamma sign

Now we can move to practical considerations, how do we know if our vertical spread will be long or short gamma when we enter into it ? If you don’t want to compute the gamma of the position with your trading software we can know the sign with a simple rule of thumb.

- If the short leg of the spread is ITM or near the ATM value, then we have a short gamma spread.
- If the short leg of the spread is OTM then it is very likely we have a long gamma spread.

For the simple rules ITM and OTM are defined based on if the spread is Bullish or Bearish, it has nothing to do with what kind of options are used to implement the spread.

For example, a bullish vertical spread in SPX could be implemented with the following strikes:

Vertical spread at 2220/2230.

For the spread to be bullish you have to buy the 2220 strike (long leg) and sell the 2230 strike (short leg).  It doesn’t matter if puts are used or calls are used, it is the same thing: a bullish vertical spread. Also because the short leg of the spread (the 2230 strike) is OTM (because this is a bullish spread and it is above the current value of SPX) then we know that our vertical spread will be long gamma when we enter it and therefore will suffer time decay as time passes.

Now let’s make the same spread bearish this time using the same strikes. For that we need to sell the 2220 strike (short leg) and buy the 2230 strike (long leg). Again it doesn’t matter a bit if we use calls or puts. We get exactly the same bearish spread, and also because the short leg is now ITM (the 2220 strike is ITM now given that SPX is below that below) then our spread will be short gamma when we enter it. In other words that spread will make money with the passing of time .

So as you can see depending on where the short leg of the spread is (based on wether our spread is bearish or bullish) then will be directional (long gamma) or neutral/directional (short gamma). Some people love collecting the time decay premium (short gamma) but be aware that losses can accumulate rapidly if the move is against you. Conversely long gamma spreads can make lots of money but if the move doesn’t happen right away then you are going to lose money to time decay (although not as much as if you were playing with a single option).

The next post is about how to setup the spreads using the Gamma Optimizer.