Is short-gamma inherently a losing strategy?

Question

With regards to a recent blowup of optionsellers.com - several analysts (specially on Quora) are blaming it on their strategy of being short gamma i.e. selling options. Is it correct to call short-gamma "picking up pennies in front of a steam rollers"?

I am not convinced that this is the right explanation, because putwrite indexes that long T-bills (collateral for covered put-writing) and short index options do not blow up - or at least haven't yet. Some have exhibited better sharpe ratio than the underlying. Optionsellers.com people were selling naked puts on volatile commodities and using other people's money. I think their cowboy risk management (or lack thereof) was to blame.

What is your analysis?

References:

1. Blew up so bad clients woke up with negative balances - https://www.ft.com/content/b7c525f6-ec44-11e8-89c8-d36339d835c0

2. Did not blow up - http://www.cboe.com/products/strategy-benchmark-indexes/buywrite-indexes/cboe-s-p-500-2-otm-buywrite-index-bxy/price-charts-on-bxy

P.S. My first post here. I'm not a professional. Just a software engineer who likes to study random things. Please be kinder to me than we are to you as a group on stackoverflow ;)

P.P.S If this post is inappropriate, kindly suggest edits.

Answer 1

You can't lose more than you invested by writing covered puts, because you keep enough cash to cover any potential losses from the puts. That's not to say that your losses can't be substantial, of course. The below chart shows the drawdown profile of the PutWrite index - you would have lost nearly 40% of your investment at one point.

So how did the proprietor of optionsellers.com lose all of his clients' money, and still leave them owning money to the clearing house? I think there are four possibilities. The answer is likely a bit of each.

1. He was writing uncovered (naked) options, i.e. using leverage
2. He was writing calls, not just puts (a covered call would require you to hold the underlying asset against the call you sold, rather than cash, which I doubt he did)
3. He sold short-dated options (they have much higher gamma exposure than longer dated options)
4. The biggest sin of all - he sold uncovered, short-dated calls on natural gas.

This is what happened to front month natural gas futures over the past few weeks -

A move of this size would have hurt option sellers on gamma alone. If they were selling unhedged calls, it would have hurt them on delta as well. Compounding the problem, the implied volatility of the options spiked, meaning that they became much more valuable -

So as well as losing on delta and gamma, he also lost on vega. Combining that with the leverage that he was presumably using was enough to wipe out all the accounts, leaving them with debt to the clearing house.

So I broadly agree with you - for this particular case, the losses were due to spectacularly bad risk management, and lessons can't really be drawn on option selling strategies in general. That said, option selling is always risky, and when you take losses they are likely to be concentrated in the worst possible times. Also note that the PutWrite index doesn't include Black Monday (19 Oct 1987) in its sample, which clearly makes the strategy look much better!