Navigating the Dangers of Trading with Negative Gamma
It's about mastering the risk, or at least trying to master it -- not avoiding it.
Professor Mark Wolfinger,
The article Options Trading and the Importance of Adjusting Positions was really good.
I have a couple of questions for you. (NOTE: Only one portion of the asked questions will be addressed here because of length, however, future articles will address other related questions).
With regard to negative gamma, I know you mentioned that this is dangerous and risk increases as expiry gets closer -- but don't the odds diminish, making the options you sold less likely to be reached?
This is the trade-off, but is it really that dangerous or is it relatively dangerous from a mathematical standpoint?
Certainly the odds diminish. You can see that in the diminishing price of the options.
Yes, it's a trade-off.
Yes, it really is that risky, from any standpoint, but especially from the only one that really matters -- monetarily.
But it's important not to draw erroneous conclusions, and I'm not certain that you interpret my description of "it's risky" correctly. I'm not telling you to exit all positions prior to expiration.
What I've been saying is:
Most traders, who have not yet been badly burned, love collecting time decay from expiring options.
If your short options are reasonably far out of the money (OTM), there's little chance they will run in the money (ITM). But, they're very inexpensive to cover, and I don't recommend trying to make those last couple of nickels. In fact, the position you describe should already have been covered. I buy those spreads early to exit the trade. Think in terms of risk and reward.
If the short options are not too far OTM, then they always feel too expensive to buy. All else being equal, the time premium in the option is half (with one week to go) of what it was with four weeks to go. When expiration is near, all most traders can see is the ticking clock and the wonderful positive theta: "If just one more day passes quietly, the position should make such and such."
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