Collecting time decay involves risk.

Option traders face different risks when dealing with options. Positive Theta (time decay) can benefit traders, but it comes with negative Gamma, leading to potential significant losses. On the other hand, some traders prefer owning options for the chance of occasional large profits. However, this position involves negative Theta, resulting in consistent losses unless the asset price moves enough to counter time decay. Deciding whether to sell or buy options is a critical choice for beginners in options trading.

For newcomers, the Greeks are measures used to assess risk in options trading.

Find Your Comfort Zone

The key for options traders in the long run is to find what makes them feel most comfortable. If you're considering taking the risk of having negative Gamma positions, the best way to minimize that risk is by owning positions that have limited risk. For instance, for every option you sell, buy another option of the same type (either a call or a put) that costs less. A good suggestion is to trade credit spreads instead of selling options without protection.

Now, if you're opting for a position with positive Gamma, let's say you own an out-of-the-money call option. Here's an example:

Stock Price: ₹74

Strike Price: ₹80

Days Remaining until Expiration: 35

Volatility: 27

The estimated value is ₹0.61 (as per the Options Calculator).

If the stock goes up, you might make a profit. But be aware that because of negative Theta, if a lot of time goes by, the option might lose value, even if the stock is doing well.

An Example

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Gamma tends to rise as the stock price goes up, but this increase slows down as the option delta approaches 50. To understand why gamma stops increasing at a certain point, imagine if the stock reaches ₹200. At this level, the option's delta would be 100, meaning it moves in sync with the stock price. Delta cannot exceed 100, so there's a limit where Delta won't keep rising.

As the stock goes up, the Delta increases until it reaches 100. So, for every ₹1 change in the stock price, the option gains more value, making its value rise faster.

When the option was bought, its Delta was 19 (the table shows 16-Delta a week later). If the stock had reached ₹76, it was expected to earn about ₹38 (2 times 19). However, it only gained ₹24 according to the table because time had passed. Without time passing, it would have gained ₹47.

With another 2-point increase in the stock to ₹78, the option gained ₹0.62. This is higher than the gain from the previous 2-point increase. When it went up another 2 points to ₹80, it gained ₹92. Again, the earning rate increased.

As the Delta goes up, call options earn more money as the stock rises. So, Gamma plays a significant role in the profit or loss potential of option trading. A 19-Delta option became a 52-Delta option when the stock price rose from ₹74 to ₹80 in a week. Gamma has a big impact!

A Second-Order Greek

Gamma is like a "helper" Greek because it shows how another Greek, called Delta, changes when the stock price moves. When Gamma went up from 4.4 to 6.5, it boosted the Delta, which meant more profits for the call owner. Plus, it made those profits grow faster as Gamma got bigger.

In short, having positive Gamma is great for an option owner, but it comes with a cost called Theta. Positive Gamma increases the helpful Delta (good for call owners when stocks rise and for put owners when stocks fall). Simply put:

What About Negative Gamma?

In the previous scenario, the option owner enjoyed a good outcome, but for the person who sold the option without a hedge, the situation looks quite different. They are dealing with negative Gamma.

• If you've sold a put option and the market is dropping, you'll lose money faster due to negative Gamma.

• Similarly, if you've sold a call option and the market is going up, the loss of money speeds up because of negative Gamma.

To put it simply:

Negative Gamma worsens the situation.

Earning a Profit with Negative Gamma

Why might a trader choose to accept the risk of having negative-Gamma positions? For the option holder to make a profit, the underlying stock needs to move in specific ways.

• Move in the correct direction (up for calls, down for puts)
• Move rapidly to avoid losing too much money due to Theta (time decay)
• Move a sufficient distance to offset the expense of purchasing the option

Predicting market direction can be challenging for many traders, especially without a fixed timeframe. However, unlike most traders, the option seller stands a fair chance to make a profit, which makes negative gamma positions appealing.

When dealing with negative Gamma positions, it's helpful to use a risk graph to understand potential losses or when the situation becomes too risky for you. The Greeks — Gamma, Theta, and Delta — can assist in figuring out the price level that should signal a warning. By recognizing these indicators, you can lower risks and aim for profits.