Tuesday, July 3, 2012

theta = a rent to own gamma (my take

* large positive gamma ~ large theta decay. Note theta is always negative since option valuation always decays with time.
* small positive gamma ~ small theta decay.

The extreme cases often help us simplify and better remember the basics --
- Large gamma is characteristic of ATM options
- Small gamma is for deep ITM/OTM options.

Some say "theta is a rent to own gamma". Imagine you delta hedged your ATM long position -- long gamma. Long gamma gives you upside profit potential whether underlier moves up or down. That's an enviable position, but comes at a "rent" -- With every day passing, you position loses value thanks to decay. The loss amount is the daily theta value (always negative). The larger the "upside" (gamma), the higher the daily rent (theta).

Negative gamma is for short option positions {large Negative gamma ~ large Positive theta}. In this blog we focus on long call/put positions either European or American style, so all gammas are positive.

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