While the topic of this article proves somewhat advanced, it's not necessary to understand every bit of the discussion to capture the main point. If you're not familiar with the Greeks of options pricing, just skim the calculations and read for the important main point.

What's wrong with the picture presented by these numbers?

10-Contract GE JUL/AUG 9/11/13 Butterfly in Place Friday, July 10
GE Earnings Report Date: Friday, July 17
Expiration BE's: 10.20 and 11.80
Delta: 174.47
Gamma: -820.14
Theta: 55.29
Vega: -4.88

A look at a risk-analysis chart for this position would show the typical tent-shaped graph for a calendar formation. GE's then-current price was well under the tent shape that signifies the profitable area at expiration. Clearly, it wasn't the then-current price that was the problem.

Theta, the Greek that measures how much an options position is helped or hurt by the passage of time, wasn't a problem, either. It was a positive 55.24, which meant that the position theoretically gained $55.29 every day that passed, with all other parameters the same. Theta would increase as the next week progressed, too.

Two potential problems did pop up right away, even for those not knowledgeable about or even interested in the Greeks. July options were due to expire at the end of the next week, and GE was due to report on the day they stopped trading. For at least a decade, Option Investor has advised closing out most options trades before earnings, unless they're speculative trades entered by knowledgeable traders. Changing volatilities leading up to and after an earnings report can undo an options trade. For those who are interested in the Greeks, though, the position vega was only -4.88 at the close of trading on July 10, so the position was rather immune to volatility risk. An earnings report on the last day the front-month options trade adds price risk to volatility risk.

This might not be the biggest problem the position faced that July 10 day. The day ended with delta at 174.47 and gamma a startling -820.14. For those who are unfamiliar with the Greeks of option prices, don't worry too much about the specifics of the calculations shown in this paragraph and the next several. What's important is the overall conclusion, not understanding the specific calculations. If you want to learn more about the Greeks after reading this article, you can locate old series on them in the archived Options 101 and Trader's Corner articles.

Delta describes how much an option's price would theoretically change with a one-point change in the price of the underlying. A positive position delta of 174.47 means that the position would theoretically gain $174.47 for each point GE gains and lose $174.47 for each point that GE loses.

Gamma tells how much delta will change for each one-point change in the underlying. A negative value for gamma means the gamma effect would change delta in opposition to price movement. For example, if GE prices dropped a point, delta rises, by 820.14 in this case. The position gets more long, in other words, as price goes down, and so is hurt more with each succeeding drop in price. If GE prices rose, delta drops and goes deeply negative. The position gets more short, in other words, as prices rise. The position is hurt either way.

This huge negative gamma going into option expiration week put the position at high risk. A one-point rise in price movement, in the absence of any other changes, would theoretically change delta in this manner: 174.47 - 820.14 = -645.67. That would mean that the position would theoretically lose $645.67 for each one-point further rise in GE's price. If GE dropped a point, delta would move in this manner: 174.47 + 820.14 = +994.61. That's a whopping number that would mean that if GE dropped another point after that, the position would lose $994.61!

In all honesty, I wondered if those delta and gamma figures could be correct since they were so large. I used another source to run a theoretical calculation on an option pricer. That calculation seemed to go along with what the previous calculations had shown. It predicted that if GE's price dropped to $9.50 on 7/14, with volatility rising by +0.50 percent during that time, delta would be a hugely positive +825.02. This would be a position that was very long delta and vulnerable to substantial losses if price continued to drop. That didn't happen, of course, with GE trading above $11.50 most of 7/17.

On page 339 of Trading Options as a Professional, James Bittman warns, "In the case of short options, the position delta does not fully state the risk because a stock-price change against the position will cause the position delta to increase adversely, generating a loss that grows at an increasing rate. This effect is known as negative gamma." Earlier, on page 99, he explains how gamma changes, noting that "gammas are biggest when options are at the money, and they increase as expiration approaches." The negative gamma effect makes the position particularly sensitive to any changes in the underlying's price, with that sensitivity hurting the writer of the front-month call.

I don't usually pay much attention to gamma, but that's a mistake during option expiration week as this example was intended to illustrate. What was wrong with that picture portrayed by the original information was that the hugely negative gamma pointed out how dangerous price change could be as expiration and earnings approached, with earnings capable of moving the price. If you didn't understand all the calculations, that's okay. What you're meant to understand is that gamma's impact increases during option expiration week, and a negative gamma hurts the position on the way up and the way down.

Particularly if you're in positions that require you to sell options as part of the complex position, know that negative gamma and approaching expiration can conspire to wreak havoc on your position. I like to close out as many positions as possible before option expiration for this and other reasons. Perhaps you should, too.