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Gamma Hemorrhage

The third quarter of 2008 made veterans out of option traders that did not want to become veterans.  After the fall of Lehman Brothers, option trading experienced persistent market dislocations that had never occurred in the history of options trading.  Yes, Black Monday 1987 was a vastly horrific day, but the persistent market volatility of late 2008 was only surpassed by the great depression.  For the “sophisticated” option traders and delta hedgers, it caused more than a few grey hairs.  In fact, the stress testing and VaR calculations that preceded 2008 would never tell you that you should prepare for Sep-Dec 2008.  In reality, market dislocations during late 2008 provides a great stress test for any strategy that you could possibly contemplate.

In a follow-up to our explanation of delta hedging, how about we look at the same simple strategy going through the post-Lehman world.  I was looking for actual option data, but after the CBOE option ticker methodology change in 2010 it is a bit difficult.  Instead, I will look at a simple October 2008 struck puts on SPY using implied volatility from the VIX which is close enough for our purposes.

Assume that on September 11th, 2008 you sold 5 contracts of the $120 strike October put and 5 contracts of the $110 strike October put.  You feel that the sub-prime turbulence, past buyout of Bear Stearns, and rumors about Lehman Brothers provide a ripe opportunity to sell put options at attractive implied volatility levels.  You are willing to risk 500*$120+500*110 = $115,000 on this trade.  Then reality sets in:

So you might have thought you were a smart naked put seller with that $948 of premium for less than a month…which would equate to $948*12/115,000 = 10% in annual premium!  On the flip side, if you sold those naked options with a bit over a month left to expiration, you would have lost $20k in that month, or about 18% in a single month.  If you delta hedged that portfolio you were still down $5.4k or about 5% of principal at risk.  Now just think of you had a large leveraged portfolio of these options and some longer dated positions that were very sensitive to changes in implied volatility….  Who could ever comprehend how Hartford got into trouble…


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3 Responses

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  1. GammaNovice says

    Why focus on gamma trading now? Are you worried this is currently a unseen market risk?

  2. Maverick707 says

    Hi Surly Trader, thanks for this . This was very helpful. I often sell naked puts with leverage more then my marginable account so I can not cover all my positions in the event of multiple assignments. This means I would have to buy to close many of my naked puts and after sharing this example I realized that I would likely be forced to buy back a number of these puts at very large magnitude losses. This has me seriously re-considering the number of naked put trades I put on and the amount of leverage I employ.

    Once again thanks. I really like the site and refer to it regularly. Keep up the good work. If you do not mind me asking, what is your background? Did you work in the finance industry previously?

  3. Joshua says

    I’m in the same boat with Maverick. I’m definately rethinking about my current size as well. Great teaching.

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