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Gamma scalping is a strategy implemented by options traders. Traders use the spot market, the market that offers immediate delivery, to hedge their positions in options. Gamma scalping allows traders to take advantage of market movement, whether up or down, at the time that it happens. They re-center their positions, in effect, so they can profit from future movements — even if those movements cancel out the profits the traders had already locked in.
There are two classes of options: puts and calls. A put gives its holder the ability to sell the stock at a certain price, called the strike price. A call gives the holder the ability to buy the stock at the strike price. Buying both a put and a call for the same underlying stock and with the same strike price is called purchasing a straddle. Gamma scalping is used by investors who have purchased a straddle to take advantage of temporary swings in the market.
Options have various measures that describe the effects of market factors on their value. One of these is the delta, which measures the rate of change of the value of the option with respect to the rate of change of the value of the underlying asset. The gamma of an option is a measure of the rate of change of the delta. Standard options have positive gammas.
Holders of straddles profit from market changes in either direction. The profit, however, is contingent on the change in the market persisting until the expiration date of the options, when profit can be realized. If the market goes up and then comes back down, then the profit evaporates as the value of the trader’s position goes back down. Gamma scalping allows the trader to realize some of the profit from market movements before the market can move in the opposite direction.
In gamma scalping, a trader purchases straddles at some initial price. The delta of the call is positive, while the delta of the put is negative. Their sum is zero. If the market moves in some direction, the deltas change. Then, their sum is no longer zero.
When the deltas are no longer balanced, the trader implements the strategy. If the price of the underlying asset went down, then the new delta sum is negative. The investor buys the underlying asset, which has a delta of one, in the spot market to rebalance the delta. If the price of the underlying asset went up, then the investor sells the underlying asset. Bringing the delta back into balance allows the investor to go back to a neutral position, from which he can profit regardless of the direction of subsequent market movements.
The risk that straddle holders face is that the market will remain stable. When this happens, they lose money by remaining passive. This process is called bleeding. The options decrease in value according to two measures: theta, which describes the decrease in the value of an option as a result of the decrease in time until the expiration date, and vega, a measure of the decrease in the value of an option with respect to decreasing volatility of the underlying asset. As long as the market moves in some direction, gamma scalpers can profit.