When short gamma trading is your only hope

From early March through last Friday, there were really only a few ways to make any profits in the S&P 500, and looking at which strategies have been working gives us a good sense for the character of this market. First, let’s take a look at price action over this period. SPX went basically nowhere:

Fig. 1. S&P 500 Index, March 6 – April 18. Source: CBOE

Now, trading strategies can be classified according to the source of their risks/returns, meaning that we can sort strategies into the buckets known as option greeks. For example, a buy and hold investor is long deltas; a mean reversion strategy is short gamma. What sort of risk exposure worked well recently?

1. Owning deltas means profiting from a directional move in the underlying. Owning deltas, whether positive or negative, was not a winner over this period. The market made a round trip back to 1,540.

2. Owning gamma (by buying calls or puts, or both) means profiting from convexity. It’s analogous to a trend-following strategy in which you commit more capital as momentum builds. That didn’t work well, either: the carrying costs in early March were recovered on the trip to 1590, but then given up (and then some) when the market reversed.

3. Theta is the cost of owning that convexity. Being long theta / short gamma worked in March and we’ll come back to this.

4. Owning vega means profiting when implied volatility in an option rises. This is where a lot of people will put up a chart of VIX and say: see, implied volatility exploded, VIX moved from 13 to 18! But that ignores the roll down costs associated with a real product. Instead, look at how May VIX futures traded over this period: they fell from 16.50 to 14, and then rallied back above 17. That means being long vega saw a drawdown during the period more than twice the size of the eventual gain. If you closed out a long May VIX position on Friday, you did so profitably but only after some rough trading.

Fig. 2. May VIX futures, March 6 – April 18. Source: CFE

The best strategy over this period was to be short gamma / long theta. The best way to adopt that sort of exposure is by trading iron condors. There are other ways to be short gamma – like selling straddles or strangles naked – but that’s a riskier and more difficult approach; a condor is essentially a short strangle covered by a long strangle. March and April were a perfect demonstration of how gamma-oriented trades can augment portfolios consisting of other strategies and investments. If the market makes a round trip, price-wise, you won’t make anything by owning shares, and if implied volatility is flat or higher, short volatility trades will struggle to pay their way. But no matter what else happens, time still passes, and in this sort of market, it pays to be on the right side of time.