Risks of a Delta-Neutral, Gamma-Neutral Call Ratio Spread

# Gamma-neutral delta-neutral call ratio spread


# Gamma-neutral delta-neutral call ratio spread












I have been looking into options strategies that minimize risk via delta neutrality. One such strategy seems to be the gamma-neutral delta-neutral call ratio spread, in which the gamma is neutralized by buying calls with a lower strike and selling more calls with a higher strike, and the delta is neutralized by shorting the stock. As time passes, it seems like the strategy will naturally result in a profit via theta decay, since the position is theta-positive. I specifically read about this here: https://www.investopedia.com/articles/optioninvestor/07/gamm_delta_neutral.asp

Assuming these positions are opened at the start of the week and closed at the end of the week, what are the risks associated with this strategy? The only one I can think of is a huge move in the underlying that significantly alters the delta of the position, but this seems unlikely for the most part since stocks rarely make such moves in a week.

## Answer by klib (score 1, accepted)

https://quant.stackexchange.com/a/65786

You are generally correct in thinking that this strategy should make money most of the time, however I would warn you to be very careful with strategies that earn a small amount of money most of the time but lose many multiples of that when things go wrong. These are examples of “picking up pennies in front of a steamroller”. The options market is full of these strategies. Here are some other risks and drawbacks:

- You will probably need to sell many more calls than you bought to achieve your desired greeks (flat gamma + receiving a credit). I suggest you pull up option quotes on yahoo finance and see what ratio is needed yourself. One example I found is buying the Apple Aug 20th 160/175 1x3 with Apple trading \$136. You can buy this call ratio and receive a credit of 0.10. Increasing the ratio makes your drawdown when the stock actually moves up significantly worse. In my Apple example you would make ~0.02 (\$2) each week if the stock didn’t rally significantly but you would lose ~5.5 (\$550) if the stock ever rallied to \$175. This would wipe out 275 winning trades in a row!

- If your plan is to roll the option strategy before it expires the underlying does not need to move as much before you start losing money. Below is a chart I created using the Apple example above and this tool. Notice that even if you close the strategy in one week you will start drawing down much sooner than the expiration payoff would indicate.

- The amount of theta the structure collects in one week may not be enough to cover execution costs. Let’s look at our example, we collected 0.10 (\$10 per 1 structure) and since you are planning on closing it in one week we should only expect to collect a fraction of this if the stock stays in the same range. Let’s make the incorrect assumption it will linearly decay for simplicity's sake. This means we will get 7/52 * 0.10 in theta after one week since there are 52 days until the expiration date. This only ends up being 0.0135. My broker charges about \$2.5 per trade in an options structure like this. That means we would have lost money entering and exiting the trade in one week (\$5 in commissions vs \$1.35 in theta).

- There is a chance the implied vol surface reprices in a way that you lose money over one week even if the stock does nothing. This means the implied vol of the calls you sold went up significantly relative to the call you own.

- Since there is a possibility of unlimited loss with this strategy your broker will likely charge a hefty initial margin to hold the trade. My broker would charge me $2,750 for one structure using the Apple example. This means from a return on capital perspective the trade isn’t very good. Even if we made 0.02 every week the annualized return on capital would be something like 3.8% which is poor for a strategy with unlimited loss potential.

I highly recommend you go through checking the payoff diagram, return on capital, and execution costs with some real world data to build your intuition further. Lastly, you will be able to find opportunities that look better than my example, however it may be because the drawdown begins sooner, the ratio is higher, or the market believes a sharp move up has a higher probability than my example.