A Rare (Good) Example of Why Gamma Matters to Option Traders

Posted by jbrumley on April 19, 2017 2:48 PM
gamma

A couple of months ago we made the point that, although high-priced stocks tend to make their options similarly expensive, the cost may be worth it. Those stocks -- we used Tesla (TSLA) as our guinea pig -- tend to move in big steps. Since their deltas are just as strong as any other option, the proverbial bang you get for your buck is adequate. The high cost can be abated simply by trading fewer contracts. Gamma doesn't make a big difference.... at least in that case.

When you want to trade a lower-priced stock though, and the options don't cost quite as much, this is where gamma can make a big difference -- particularly if there's not much time left until the option's expiration.

It was a matter that came up Wednesday, when our Weekly Options Accelerator trading service stepped into some near-term MGM Resorts (MGM) calls in anticipation of a continued bullish thrust. While delta still played a key role in which call option we chose, this is a case where gamma was a key consideration.

As a quick refresher, gamma is the rate at which delta changes when the underlying stock moves $1.00, while delta is the rate at which the option changes price when the underlying stock moves $1.00. Generally speaking, you want a high delta so your option moves a lot, in step with the stock you're making a play on. And, generally speaking, you'd like to have a higher gamma than not, since it means your option's delta improves as progress is made, meaning the trade becomes even more responsive as it wears on.

Of course, high deltas and high gammas can also backfire, should you not correctly predict the direction of the stock you're buying options on. As we mentioned a couple of weeks ago, to get a good feel for the "what if" scenarios of a particular option trade, you really have to crunch all the numbers and possibilities to find the optimal risk/reward scenario.

We'll do that below for MGM, but first things first... a look at the chart.

There's actually a lot working in factor of MGM Resorts shares here, not the least of which is what sparked the current rally - the triple bottom at $25.24. But, it was the renewed cross back above the 100-day moving average line (gray) today that sealed the deal. [Note that the Weekly Options Accelerator service uses a whole different set of technical criteria, but we can't give our proprietary tools away.]

041917-mgm

Less objective and more subjective is the fact that the bearish gap left behind in February has yet to be fully filled in, and there's not necessarily an absolute ceiling until we get to January's highs around $30.00. From the current price of $28.15, that's enough room to squeeze in a decent trade from MGM, jumping on while the momentum is clearly hot... yesterday and today have been decidedly bullish.

So, we know (1) this is going to be a pretty short-term trade, and (2) at best we'll be able to get about $2.00 worth of movement out of the stock before a headwind is hit.

With those realities in mind, we can automatically narrow down our search to the options that are (1) expiring in just a few days -- as in at the end of this week -- and (2) are a little but not too deep in the money. The grid below shows all the call possibilities worth considering.

041917-mgm-options

Considering how little time we'll have left, we can rule out the 28.00 and 28.50 strikes. Both of their deltas are below 0.70 (meaning they move less than 70 cents for every dollar MGM gains). Yes, both have large gamma, in excess of 0.30, which means the deltas would improve very quickly should MGM Resorts continue to rally.  That's an awfully big risk though... one we're not willing to take with just three days left on the trade.

However, any strike below 27.50 has essentially maxed out its delta; all of them would respond similarly well if MGM keeps moving. Take a look at the gammas for those options though. With the exception of the 26.50 and 27.00 strikes, gammas are zero because all the deltas for strikes below 26.50 are (literally) maxed out. The responsiveness won't improve even if their prices do. For the 26.50 and 27.00 strikes though, the more MGM moves higher, the better the delta gets and the faster we put gains under our belt.

You'll also notice the big difference in price between the 26.50 and 26.00 strikes. To get a full-delta option, we have to start paying more than $2.00 per contract. There's nothing inherently wrong with that, but at this point we have to start considering our total return potential on the price we pay. If we can keep the cost under $2.00 per contract, in this case that will help...  a lot.

Here are all the possible profit and loss scenarios for all three options we'd consider. In terms of the total potential dollars gained, the 26.0 strike and the 26.50 strike are essentially the same. The only key difference here is the price; it would cost about 3/4 the price of the 26.0 strike to buy the 26.5 strike, which translates into much higher percentage-gain potential... about 30% more (an all scenarios). That's where a little extra gamma goes a long way.

041917-mgm-pl

The 27.0 strike has more upside in terms potential percentage gain, but it wouldn't take much of an adverse move to really wipe out even that smaller amount ($120) we'd put toward that trade. It's just not worth it.

Obviously you can't weigh every possible scenario with every trade, but you don't have to. Sooner than later you get a feel for what makes the most sense. This is still a great example, however, of how gamma can make a difference in your trade selection. The cheaper 26.50 strike has almost the same risk/reward profile as the 26.00 strike does, because gamma really cranked up delta once the trade put a little distance behind it.

By the way, we ended up locking in a 20% gain on the MGM April 22nd 26.50 calls on Wednesday, making an exit on the same day we entered the trade. We could have held out for more, but some opf the other underlying technicals we watch changed shortly after we stepped in. That's fine though... 20% in a couple of hours is nothing to lament. More important though, we were able to book that 20% profit because we had the optimal mix of delta and gamma.

To learn more about the Weekly Options Accelerator service, go here.

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