Most Important Option Relationship: Delta/Gamma

In the late 80’s, my morning train ritual was pretty much the same. First half of the ride, sports section and coffee. The second half of the ride involved a crucial phone call that would be a big determinant of my happiness for the day.

It was the call to my clerk on the trading floor of The CBOE. It went something like this, “ Hey Todd, how are the overseas markets doing and how are my stocks looking pre-opening?“ Todd might reply something like this, “ Europe is down pretty good and IBM is projected down $2.00 at the opening”. My pleasant train ride was suddenly getting a bit stressful. I nervously asked the key question that would make me happy or nauseated, “ Todd, what are my deltas and gammas in IBM?” Waiting for his response , panic started to set in. “ Dan, your deltas are 2000 long and your gamma is short 5000". Not good! This meant that if IBM opened $2.00 lower as projected, my new IBM deltas would be about 12,000 long.

When you are short gamma, if the stock goes down $1.00, you pick up more long deltas equal to the amount of the gamma. In English, the stock is down $2.00 and I’m the equivalent of 12,000 shares of stock long. The first dollar down my deltas go from long 2000 to 7000 long, the second dollar down, they go from 7000 to 12,000 long. Bottom line, I’m down good coin at the beginning of the day? When the first buddy I run into at the CBOE says the morning salutation “ How you doing?” , how should I respond? I’m Long!!

Why is this relationship so important? Gamma and delta refer to price risk. Most strategies like calendars, credit spreads, butterflies, and diagonals have 2 main risks. They are implied volatility and price. Implied Volatility is very important, but I would give the nod to price as my main nemesis in the spreads I do. Managing my deltas was my most important task as a risk manager. When you let your deltas get out of whack, your P & L will usually get whacked. Controlling deltas takes planning, discipline and plain hard work. I encourage you to spend time understanding deltas and gammas and how gamma can change deltas quickly, especially near expiration.

Dan Sheridan