Gamma Scalping: A Primer

Trading short-term market movements is challenging. However, option traders who closely monitor volatility can leverage a strategy called gamma scalping to potentially profit from small movements in an underlying asset over time.

Gamma scalping—or gamma or delta-neutral hedging—is an advanced trading approach that requires experience, precision, and a studied viewpoint of the impact of volatility on an underlying security.

Understanding the greeks—specifically, the role delta and gamma play in calculating the price of an options contract—is key to grasping the gamma scalping approach.

Let's look at the financial metrics that influence options pricing, an overview of gamma scalping, and some examples of this strategy. 

The options greeks are theoretical measures of an options price's sensitivity to changes in external factors like the price of its underlying security, implied volatility, time until expiration, and interest rates.

Delta, which describes how much an options contract's value is expected to change given a $1 move in the underlying security, is one of the most important greeks to understand before implementing a gamma scalping strategy.

Traders often think of delta as the number of shares of the underlying security they'd need to own for it to mimic the behavior of the option when gamma scalping. The intent of each transaction in this strategy is to re-align the offsetting underlying and options positions to neutralize the net delta.

For example, 40 shares of stock typically behave the same as a long call option with a .40 delta. With all aspects of the model being equal, if the stock price increases by $1, the options premium should theoretically increase in price by $0.40 ($40 in value), and the 40 stock shares will also gain a collective $40 in value.

That brings us to gamma, which reveals how much the delta of an option will theoretically shift with a $1 move in the underlying security. If an option has a delta of .40 and a gamma of .15, its premium would theoretically increase $0.40 on the first $1 increase in the underlying security. This move brings the call option closer to being in the money (ITM) and its delta closer to 1.00. On the second $1 increase, the options premium would theoretically increase $0.55: the sum of delta (.40) and gamma (.15). Gamma decreases as the option gets further ITM because delta cannot exceed 1.00. Gamma is at its highest when the option is at the money (ATM), meaning the strike is equal to the price of the underlying security.

A long options position is essentially a long gamma position. A long option is gamma-positive, meaning rising implied volatility (IV) can be beneficial, as it typically increases the value of both calls and puts. By contrast, a long options position is more likely to lose money when IV falls. Gamma tends to be lower for stocks with relatively high IV and higher on stocks with relatively low IV.

Gamma scalping is a short-term trading strategy that capitalizes on movements in an option's delta. If a trader thinks IV is too low, they may be able to profit by buying long calls and selling the underlying stock, or by buying long puts and purchasing the underlying stock. The number of shares traded should correspond to the delta of the option to create a delta-neutral position. This differs from a protective call or protective put strategy, in which a trader hedges 100 shares of the underlying security with each options position.

Now that we've explained what gamma scalping is and why traders use this strategy, let's review two trading scenarios to illustrate its practical application.

A trader buys 10 April 520-strike calls for $12 per contract on ZYX with a delta of .29 and a gamma of .005. To hedge this position, they short 290 shares of ZYX at $475 per share. They're now long 290 delta (from their 10 long calls) and short 290 delta (from their 290 shares short ZYX).

This makes them delta-neutral, theoretically neutralizing the impact of short-term fluctuations in the stock. However, the trader is still sensitive to volatility (non-directional price movement) because they're net long .05 gamma (.005 x 10 options). Remember, greeks are strictly theoretical measures for the way options pricing will react to real-life market conditions and are not perfectly predictive.

If ZYX increases by about 1% (or $5) in one day to $480, the delta of each 520-strike call will theoretically increase to about .32, up by approximately the gamma amount of .025 (.005 x 5 points). Because the trader is long calls, they'll have to short 30 more shares of ZYX at $480—bringing their total stock holding to 320 shares—to remain delta-neutral.

After shorting 30 additional shares, the trader is long 320 delta (from their 10 long calls, which now have a delta of 0.32) and short 320 delta (from their 320 shorted shares). If ZYX falls back to $475, the delta on the calls will drop back to .29 again, and the trader will buy back 30 shares of ZYX at $475 to remain delta-neutral.

Because the sell-to-open price of $480 was about 1% higher than the purchase price of $475, the trader should gain about 1%, or $5 per share, on 30 shares of ZYX (approximately $150).

The gain is due to the trader being long gamma. If this process repeats enough times before the options expire, the cumulative gains from each gamma scalp will eventually exceed the aggregate time erosion of the options (see the table below).

However, it's important to note that short selling is an advanced trading strategy that involves potentially unlimited risk and must be done in a margin account. There is also no guarantee that a brokerage firm will continue to maintain a short position for any period of time, meaning these positions may be closed out by the firm without regard to a trader's profit or loss.

A trader buys 10 April 60-strike puts for $0.65 per contract on FAHN, with a delta of –.31 and a gamma of .094. To hedge this options position, they buy 310 shares of FAHN at $62. The trade is now delta-neutral—short 310 delta (from the 10 long puts) and long 310 delta (from the purchased shares). However, the trader is net long .94 gamma (.094 x 10 options).

If FAHN decreases 2% in one day to $60.76, the delta of each put will theoretically decrease by approximately the gamma amount of 0.116 (.094 x 1.24 points) to –0.43. Because the trader is long puts, they'll have to buy 120 more shares of FAHN at $60.76 to remain delta-neutral. After this purchase, they'll be short 430 delta (from their 10 long puts) and long 430 delta (from their 430 FAHN shares), maintaining a delta-neutral position.

If FAHN rises back to its previous price of $62, the delta on the puts will increase back to –.31, and the trader could sell 120 shares of FAHN at $62 to remain delta-neutral. Because the sale price of $62 was 2% higher than the purchase price of $60.76, the trader should gain about 2%, or $1.24 per share, on the 120 shares of FAHN (approximately $148). In theory, if this process can repeat enough times before the options expire, the total gains from gamma scalping will exceed the aggregate time erosion of the options in this example.

And remember, it doesn't matter which way the stock moves first if a trader sells high and buys low. This example would be similar if FAHN rose first—prompting the trader to sell shares—and then fell, at which point they bought shares back.

The inverse of the gamma scalping strategy is called negative gamma scalping or reverse gamma scalping. If a trader believes implied volatility is inflated, they can do the strategy in reverse by selling calls and buying stock, or selling puts and shorting stock.

In this example, the trader will sell stock when it drops in price and buy more as it increases. This often results in a loss on that trader's stock transactions. But if the actual volatility is lower than expected, the trader may still profit. That's because time erosion on their short options position may exceed the losses on their stock trades (see the table below).