Let us imagine a large volatile portfolio composed of both long and short premium positions. Long premium positions generally want the underlying to move quite a bit, while short premium positions generally want the underlying to sit still.
Said in a different way, the risk of a long premium position is that it doesn’t move, while the risk of a short premium position is that it makes a big move in the wrong direction. The gamma adjustment strategy works to help reduce these risks.
For example, by scalping movement out of a long premium position, the gamma scalping can help provide income that covers theta expenses related to the position. Along those lines, gamma hedging related to short premium positions can help reduce directional exposure if the underlying security moves against you.
Both of these ends are met through the continuous maintenance of delta-neutrality.
The main reason this type of system is known as “gamma scalping” is because the gamma dimension of the options position dictates the nature of the delta adjustment.
When purchasing options, the gamma of the overall position will be positive. Consequently, as the underlying stock rises, positive gamma positions get longer delta. As the underlying stock drops, positive gamma positions get shorter delta.
The opposite is true of negative gamma (aka “short gamma”) positions. As the underlying stock rises, short gamma positions get shorter delta. As the underlying stock drops, short gamma positions get longer delta.
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