Friday, June 9, 2017

Closing short near the Money Call to Reduce Gamma Risk on EEM Diagonal Spread

EEM has been performing OK relative to the general market last week. My EEM diagonal call spread was working fine. The short June 9 $42 call option that was sold 3 weeks ago for $0.27 was approaching its expiration date with 3 days left from Tuesday, June 6. It was near the money as EEM price was around $41.72 and Delta was around 0.46. The position had relatively high Gamma risk which could turn the short call into a significant loss in a couple of days even though the EEM price just increased a little bit to above $42. Therefore, I bought back the short call for $0.10 to eliminate Gamma risk and to lock in a profit of $0.17 on the short call on Tuesday, as I twitted in my StockTwits message.

After that, I have EEM long call January 19, 2018 $38 naked. Since it seemed to form a small ascending triangle pattern with MACD turning up and travelling in the upper trending channel as shown in the chart below, I did not sell another short call. I’ll short new calls when the stock movement provides the signal to sell.

The option’s Gamma risk could have a big impact on option strategies that include short options when the expiration date is coming closer. This is because option Gamma increases dramatically as the option approaches expiration, particularly for options At-The-Money (ATM). Therefore, many option strategies that sells options for protection and/or for benefit of time decay need to watch for Gamma risks as the expiration comes closer. This and the definition of option Gamma are very well explained in the article on Understanding Gamma by I also had a study on the option Greeks in my previous post: A Summary of Effects of Prices, Time, Volatility on Option Greeks.

The diagonal spread involves short options and therefore need to take Gamma risk into account in its option adjustment rules. There are two major impacts on diagonal spreads due to the characteristic of option Gamma. We already discussed the first impact near the expiration. This results one short option closing rule that it should be closed in the last week when the stock price is close to the option’s strike price.

The second Gamma impact on the diagonal spread is the possibility of Delta inversion. Since the option closer to expiration has higher Gamma than that of the option that is far from expiration, the Delta changes faster for the option closer to expiration as well.

Thus, the short option in a diagonal spread which is closer to the expiration may have its Delta changing quicker than that of the long option which is farther away from expiration. When the short option’s Delta exceeds the long option’s Delta, it’s called a Delta Inversion. The wider the expiration dates of the short and long options, the more frequently it’s likely to happen.

Delta inversion causes originally bullish diagonal call spreads to lose money if the stock prices continue to go up as expected. It also causes originally bearish diagonal put spreads to lose money if the stock continues to fall.

For example, a short call option may have a Delta of 0.50 while the long call option may have a Delta of 0.70. As the short option gets closer to expiration and near-the-money, its Gamma increases faster. If stock price increases $1, the Delta of the short call option may increase faster to 0.75 while the Delta of the long call option may increase slower to 0.72. So, the composite Delta of the diagonal call spread changes from +0.20 (bullish) to -0.03 (0.72-0.75, bearish). The originally bullish call diagonal spread starts to lose money if the stock prices increase as the trader expects in the beginning of the diagonal trade.

Therefore, diagonal spread management rules are required to avoid the Delta inversion in order to trade the strategy profitably. What I’ve leant is that the short option should be rolled when the composite Delta of a diagonal spread gets closer to 0.15 area, or the short option’s Delta get above 0.60. If we roll up or roll out the short call that is likely to cause Delta inversion, the composite Delta gets expanded wider to have more profit room for stock price increases. If the stock prices reverse direction from here, we can keep selling new options as well.

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