Last week I mentioned: I’m a big believer in looking at IVR and portfolio theta to figure out when to take profits in positions that have the highest P/L %. To me, it’s about dissecting the whole picture because as long as you have attractive time decay in an underlying but declining IVR, why would you take it off or roll the position out in time as boosting your daily theta isn’t necessary? The better you understand high IVR, the wider your profit zone will be and the more profit you will generate. In that regard, selling short strangles isn’t about rolling the dice, it’s about trading consistently and letting time work for you.

Gamma Risk

But what’s at the heart of rolling out in time? Why does it make sense from the options Greeks’ standpoint? It’s about gamma risk, the risk you can’t see (compare this phenomenon with carbon monoxide intoxication, it’s hard to spot it which makes it fatal to your health if you don’t take precautionary measures).

Gamma tells us how the delta will change per change in the underlying share price. Theoretically, gamma is the highest for ATM options courtesy of their binary nature (50% chance of expiring in the money, 50% of expiring out of the money) and increases along the way and the more volatile the underlying, the lower your gamma risk will be.

This seems quite logical as the lower volatility is, the smaller the expected move is and thus the higher the impact of increasing volatility on the options prices and their Greeks. But I was talking about at-the-money options, not out-of-the-money options we’d like to sell for our short strangles. Along with theta and vega, gamma should eventually approach zero about 8 days before expiration based on static price action. However, tastytrade conducted a study with the 16 delta strangles showing us gamma risk actually increases because of the whipsawing price of the SPY.

(Source: Tastytrade)

That makes a lot of sense, since gamma’s value doesn’t increase gradually but exponentially at around … 21 DTE! That was the missing piece of the “Managing Winners” puzzle! Monitoring your theta and gamma numbers makes so much sense because it’s so difficult to anticipate a suddenly spiking gamma. Why put yourself to that aggravation?

That’s also the reason why selling weekly options does make little sense from a mathematical and financial point of view. I’ve compiled the following table presenting the margin requirement for one put on SBAC (a stock that's currently in our short strangle portfolio) based on 8 DTE; 33 DTE; 68 DTE.

Why take the risk of selling premium when the delta is 10, gamma risk is noticeably higher; lower vega (which means you don’t benefit from contracting volatility as much as you would do when selling long-term options) and a high margin requirement? It simply doesn’t pay for us to wait until expiration as our capital is less efficiently deployed (less reward for the additional risk you take on). By rolling out the position, we want to circumvent gamma risk and allow our trades to work out nicely throughout the following cycle, recenter our portfolio allocation and manage some losing trades (because of higher IV, for example, causing both the short-term options and long-term options to increase in value). Rolling out simply reduces your overall risk, rebalances your portfolio, takes you to a higher short Vega (which is an ideal situation if you sell in high IVR). We can also shut down some positions because we feel the IVR is too low or because of an earnings report that's about to be published soon. Next week, I’m going to discuss correlation and why non-correlated assets reduce volatility in our daily P/L.