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If anyone can help me with this scenario I would greatly appreciate it as I've noticed it happen very often, but couldn't quite put my finger on it. I'm going to use Apple options as an example, but in reality it is the real situation.

Over the last few months Apple has been a perfect day, week and monthly trade for calls and puts. Depending on what I see in price action and sentiment I go long or short, bust mostly a long position with a hedge of some short.

Recently, I've put on a call ratio backspread. While watching the different legs of the trade, I've noticed something that I've noticed before when being short calls. It seems that whenever I'm short a call, when the position moves against me, I seem to lose significantly more then I gain when the position goes in my direction. Why is that? I would suspect it to be the other way because when I'm short I have theta in my favor as well as price movement. Volatility is the same.

Any advice, insight, experience would be greatly appreciated. Every time I think I have something under my belt the market likes to re-educate me.

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Comments (11)

  • leveRAGE.'s picture

    when you're short options you're short convexity, which means that when positions move against you, you begin to lose at an increasing rate(because of being short gamma). In that same token, when you gain on the position, you are making gains at a decreasing rate (same logic applies).

    Basically, if you're not delta hedged, and your delta begins to move against you, it will begin to move against you faster and faster. And when it moves in your favor, it will do so slower and slower.

  • IlliniProgrammer's picture

    Yup. That's the impact of convexity. One thing you may want to consider is doing bull/bear spreads instead. They're a lot more gamma neutral, though still experience positive/negative convexity around the strikes.

    One thing to be careful about when delta-hedging options positions is the Charm. In theory, if you have a delta-hedged call and the stock price is moving up quickly towards the strike, you're making money. In reality, you're losing money short the stock and until you pass the strike, you've got an option with a value of zero at expiry.

  • Revsly's picture

    Building on the convexity argument, let's say you start with spot = high-strike of the call backspread. As spot falls and you approach your short-strike, you are moving into the (likely) most short gamma portion of your structure. Conversely, as spot goes higher, you move away from the +ve gamma of the high-strike.

    Jack: They're all former investment bankers who were laid off from that economic crisis that Nancy Pelosi caused. They have zero real world skills, but God they work hard.
    -30 Rock

  • tyrets's picture

    Thanks guys. I appreciate it. I know short gamma is always a bad move, but I was really baffled on why the short loses more relative to the long gaining.

  • IlliniProgrammer's picture

    Short gamma isn't always a bad move- you get paid for that convexity. It is just a move that you have comprehensively understand before you get into it. You go short gamma because vol is really expensive for no good reason, and then generally on behalf of an investment bank or trading firm rather than a personal account.

    I will go long gamma and sometimes do bull/bear spreads in a personal account but stay away from the more complicated strategies.

  • In reply to IlliniProgrammer
    tyrets's picture

    What would be your best recommendation for getting a better grasp on convexity in a context that is less complex as Hull, if possible? I do have a decent grasp on the greeks in general, but where I need work is with application of principles. I can sit here and regurgitate what I've learned and read, but I need to better apply it.

    Is this possible, or is it solely from experience? Keep paper trading strategies and theories, perhaps?

    quote=IlliniProgrammer]Short gamma isn't always a bad move- you get paid for that convexity. It is just a move that you have comprehensively understand before you get into it. You go short gamma because vol is really expensive for no good reason, and then generally on behalf of an investment bank or trading firm rather than a personal account.

    I will go long gamma and sometimes do bull/bear spreads in a personal account but stay away from the more complicated strategies.[/quote]

  • IlliniProgrammer's picture

    Just have to get experience at it and a strong working knowledge of it. You also need a strong analytics toolkit- one that can give you current strike vols, historical vol, etc. If you work with options or vol products as a quant on a full-time basis, you will get comfortable with all of this stuff- moreso if you are a trader.

    I will spot some anomaly in the vol market and see if there's anything I can do with my limited PA choices on vol strategies- (long call, long put, bear/bull spread) to fix it. Going just long vol, I lose everything 70% of the time, but quadruple my money the other 30%.

    It is a tough market if your counterparty is professional market-makers, but they still make enough mistakes that a smart person can still win in this game.

  • derivstrading's picture

    if you have a rough idea of the greeks for calls and puts, the best thing to do is to take a pen and piece of paper, put on some music and try to draw out the greeks of straddles, call spreads, risk reversals, butterfiels, calendar spreads. Once you have that and you feel comfortable with it, move on to the second order greeks, most importantly change of the greeks with respect to vol/time.

    Trust me, if you devote a couple solid hours to this you will have a great grasp of the greeks.

  • Chim Chim's picture

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  • Revsly's picture

    Jack: They're all former investment bankers who were laid off from that economic crisis that Nancy Pelosi caused. They have zero real world skills, but God they work hard.
    -30 Rock