Short gamma trade - a bad idea

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Information about Short gamma trade - a bad idea
Finance

Published on March 13, 2014

Author: stefanbolta

Source: slideshare.net

Description

Why is shorting gamma bad and unsustainable over the LT.

Why  Being  Short  GAMMA  is  a  bad   specula9ve  idea  over  the  long  term   Made  by  a  “Theorist”     Dedicated  to  all  the  “Prac9cal  People”   Powered  by:  N.N.  Taleb   Best  works  with  Free  Adver9sing:  Fannie  Mae,  Indy  Mac  and  Lehman   Brothers  

The  main  idea  behind  any  strategy   that  involves  wri9ng  (short  gamma)     an  out  of  money  op9on  is  to  put  up  a   collateral  and  generate  posi9ve  cash   flow  that  can  be  reinvested  while  the   expecta9on  of  op9on  exercise  is   strongly  biased  towards  ending  out-­‐of-­‐ money.    

In  other  words,  for  only  a  frac9on  of   the  no9onal  value  of  a  contract,   op9on  sellers  are  willing  to  assume   from  their  counterparty  the  risk  of  any   expected  or  unexpected  move  in  the   underlying.  They  assume  a  large  move   is  highly  unlikely.  

A  general  problem  with  this  kind  of   strategy  is  they  predic9vely  yield  a   CAPPED  GAIN  while  assuming   UNCAPPED  CAPITAL  RISK.  

The  consequence:  Decep9vely  steady   income  that  can  last  for  sustained   periods  (if  the  vola9lity  is  low*),   sudden  unlimited  capital  loss**.   *  Like  right  now,  March  12th,  2014   **  Like  the  one  on  October  19th  1987,  October  15th  2008,  August  31st  1998,  August  8th  2011,  etc.   Out  of  TOP  20  historically  largest  S&P500  daily  loses,  11  happened  aber  2007.  All  in  excess   Of  5.00%.  The  risk  of  capital  loss  is  not  only  limited  to  the  contract  itself  but  also  to  the  collateral   meaning  there  exists  certain  risk  of  correla9on  in  the  downward  move  between  the  underlying     and  the  collateral.  

Why  is  this  so?  

Implication of being SHORT an option contract! Taleb, N (2013): No, Small Probabilities are Not Attractive to Sell': A Comment! P/L! (theta)! IV Std. Dev.!

Why  Being  Short  GAMMA  is  a  bad  specula9ve  idea  over  the  long  term! Implication of being SHORT an option contract! Expected Payoff ! from Selling an Option   Indy Mac! Annual Earnings   Taleb, N (2013): No, Small Probabilities are Not’ ttractive to Sell': A Comment!

The Problem: Tail Risk! Kurtosis  over  time:  example  of  an  “in4inite   moment”.  The  graph  shows  the  fourth  moment   for  crude  oil  in  annual  nonoverlapping   observations  between  1982  and  2008.  The   instability  shows  in  the  dependence  of  the   measurement  on  the  observation  window.      

The Problem: Tail Risk! Taleb:  Selected  Lectures  on  Risk  (2012)     Monthly  delivered  vola9lity  in  the  SP500  (as  measured  by   standard  devia9ons).  The  only  structure  it  seems  to  have   comes  from  the  fact  that  it  is  bounded  at  0.  This  is  standard.   Monthly  vola9lity  of  vola9lity  from  the  same  dataset,   predictably  unstable.  

The Problem: Tail Risk! Taleb:  Selected  Lectures  on  Risk  (2012)    

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