Could someone please outliine the method of gamma scapling?ThanksJames

suppose you are long 1000 calls (contract size 100) with a delta of 0.6 priced with a vol of 16.to be delta neutral you sell 60000 shares.since you are long an option you are gamma long meaning if the underlying price increases your delta increases and vice versa.If the stock moves up 1% your delta increases to, say, 0.63So, to adust your delta hedge you gotta short 3000 shares at the 1% higher price.If the stock comes back to its initial level the next day the option delta is approximately at 0.6 again (neglecting dDelta/dTime)you gotta buy back the 3000 shares you sold the day before.Sell high - buy back lower. that`s fun, isn`t?This delta re-adjusting is called Gamma scalping.you were hedge the whole time. So, riskless profit???Try to check how the option price changed from one day to the next.Recalc everything with a move of 0.5% and with 1.5%Where is the break even and how is it linked to the 16 vol priced in?

Thanks baghead, i thought it was more complicated than that.So gamma scalping is just a standard delta neutral long vol play for which you pay your theta decay?at 16 vol you want the underlying to move on average 16/(252)^0.5 each day, correct?

QuoteOriginally posted by: JamesH83Thanks baghead, i thought it was more complicated than that.So gamma scalping is just a standard delta neutral long vol play for which you pay your theta decay?at 16 vol you want the underlying to move on average 16/(252)^0.5 each day, correct?correctamente...I wouldn`t say "long vol" `cause your vega is almost nil when gamma starts to be real fun (close to maturity) and when it comes to calendars you are usually gamma long and vega short.... but we don`t wanna split hairs...

sure, see what your saying as regards gamma vs vega.Is the frequency of rehedging just down to the traders short term directional view on the underlying, or is there any standard method?

I think some auto trading methods hedge every 1/2 hour or hour for overnight optionsFor manually hedged options, I've seen traders rehedging every 20 / 25 pips (for underlyin vols of about 10%)Is it a widespread rule?

Surely it must depend on the transaction costs associated with trading the underlying?Quant, one other question that I had that you will be able to answer, how large are the bid-ask spreads in vol terms on FX options on the major currency pairs? How much do they change over the trading day and over strike?James

James - for a very standard option, say: EURUSD, exp 1m, ATM , notional 100M, you can expect a vol spread around 0.2 / 0.3 (also depends on the bank quoting the price of course!)The spread increases with the notional size (esp. above 500M/1 yard) and with the "OTM-ness" (below 25 delta)It also increases when quoting back end options (more than 1y) or very short dates (overnite to 1w)I have somewhere a spreadsheet summarizing spreads used by a major FX bank, for different ccy pairs/ maturity/sizes.I can send it over to you if you're interested.I also have the one used by my desk but I guess this one is proprietary

QuoteOriginally posted by: JamesH83So gamma scalping is just a standard delta neutral long vol play for which you pay your theta decay?Here is a more general method that enables you to scalp volga as well as gamma.Dynamically hedge your net position such that:1. You are delta-neutral.2. You are vega-neutral.3. You have positive gamma.4. You have positive volga.5. You have gamma*volga > (vanna)^2.This may be difficult to maintain, but if you can, then you will be at the bottom of a "profit well". It's a standard theorem in analysis that whatever directions spot and volatility move, together or independently, the value of your position will always increase. However it is not a risk-less profit because theta will lower the bottom of your well over time. On average it will keep you hedged against theta. If spot and volatility are changing rapidly, however, then you'll make a profit. If they are frozen, you'll make a loss. If you can build this position with mis-priced contracts, then you may be able to cut out most or even all of your theta and guarantee a profit!! (All this ignores trading costs, of course. It also depends on how you calculate your position vega, volga and vanna, since, strictly speaking, you need to do this with respect to a unique common indicator of volatility, not IVs.)

Hi Fermion,Thanks for your post.Would you mind briefing explaining what volga and vanna are?They are sensitivites in a stochastic vol model such as Heston right?

volga = dvega / dvolvanna = dvega / dspot = ddelta / dvol Fermion: why is the condition (volga * gamma > vanna ^ 2) important ?

oh ok, i thought people just said dvega / dvol.anyways in a stochastic vol model is there a name for the sensitivity with respect to vol of vol?

QuoteOriginally posted by: quantstudent19volga = dvega / dvolvanna = dvega / dspot = ddelta / dvol Fermion: why is the condition (volga * gamma > vanna ^ 2) important ?Gamma > 0 gives you a 1-dimensional well along the spot axis. Volga > 0 likewise along the volatility axis. The extra condition you ask about prevents leakage from the well in any other direction in the 2-d spot/volatility plane. (It guarantees a 2-d minimum.)I dug out my old Analysis text-book from when I was an undergraduate. The book is "A Course Of Analysis" by E.G.Phillips, CUP 1962. The reference is section 10.5, pp256-259. See also "Partial Derivatives" by P.J.Hilton, Routledge & Kegan Paul, 1963, Chapter 4. Younger members of the forum may be able to point to more recent texts still in print .

Damned good stuff, Fermion.