What Does Gamma Mean In Options Trading?

In options trading, “gamma” is one of the Greek letters used to describe the various factors that influence the pricing and behavior of options. Gamma specifically measures the rate of change in an option’s delta in response to a one-point change in the price of the underlying asset. It is essentially the second derivative of the option’s value with respect to changes in the underlying asset’s price.

What Is Gamma?

Gamma (Γ) is an options risk metric that describes the rate of change in an option’s delta per one-point move in the underlying asset’s price. Delta is how much an option’s premium (price) will change given a one-point move in the underlying asset’s price. Therefore, gamma is a measure of how the rate of change of an option’s price will change with fluctuations in the underlying price. The higher the gamma, the more volatile the price of the option is.

Option Gamma Explained

Gamma is an important measure of the convexity of a derivative’s value in relation to the underlying asset. It is one of the “options Greeks” along with delta, rho, theta, and Vega. These are used to assess the different types of risk in options portfolios.

What Is Gamma Used for?

Since an option’s delta measure is only valid for a short period of time, gamma gives traders a more precise picture of how the option’s delta will change over time as the underlying price changes. Delta is how much the option price changes with respect to a change in the underlying asset’s price.
Gamma decreases, approaching zero, as an option gets deeper in the money and delta approaches one. Gamma also approaches zero the deeper an option gets out of the money. Gamma is at its highest when the price is at the money.

The calculation of gamma is complex and requires financial software or spreadsheets to find a precise value. However, the following demonstrates an approximate calculation of gamma. Consider a call option on an underlying stock that currently has a delta of 0.40. If the stock value increases by $1.00, the option will increase in value by 40 cents, and its delta will also change. After the $1 increase, assume the option’s delta is now 0.53. The 0.13 difference in deltas can be considered an approximate value of gamma.

Example of Gamma

Suppose a stock is trading at $10 and its option has a delta of 0.5 and a gamma of 0.10. Then, for every $1 move in the stock’s price, the delta will be adjusted by a corresponding 0.10. This means that a $1.00 increase will mean that the option’s delta will increase to 0.60. Likewise, a $1.00 decrease will result in a corresponding decline in delta to 0.40.

How Do Traders Hedge Gamma?

Gamma hedging is a strategy that tries to maintain a constant delta in an options position. This is done by buying and selling options in such a way as to offset each other, resulting in a net gamma of just around zero. At such a point, the position is said to be gamma-neutral. Often, a trader will want to maintain zero gamma around a delta-neutral (zero-delta) position as well. This is done via delta-gamma hedging, where both net delta and net gamma are close to zero. In such a case, an options position’s value is immunized against price changes in the underlying asset.

What Is a Long Gamma Strategy?

If traders are long gamma, the delta of their options position increases with price movements in the underlying asset. For example, a long gamma position will see an ever-increasing delta as the underlying price rises—or ever-decreasing deltas as the price falls. If the trader can sell deltas as prices rise and then buy deltas as prices fall, the long-gamma exposure can lead to net profits by incentivizing the trader to consistently buy low and sell high.

What Is Gamma Risk?

For options positions that are short gamma, there is a risk that price movements in the underlying will cause compounding losses. For instance, if such a position begins delta-neutral and the stock rises, it will produce increasingly short deltas for the position, so that as the underlying rises, the options will lose more and more money. The risk, however, is that if the deltas are bought at these ever higher prices, the underlying asset can reverse direction and fall, creating long deltas on the way down, compounding those earlier losses.

What Does Gamma Mean In Options

What Does Gamma Mean In Options?

Here are some key points to understand about gamma in options trading:

  1. Delta Sensitivity: Delta is another Greek letter used to represent the sensitivity of an option’s price to changes in the underlying asset’s price. Gamma measures how much the delta of an option will change when the underlying asset’s price moves by one point (usually one dollar for stocks).
  2. Gamma’s Sign: Gamma can be positive or negative, depending on whether the option is a call option or a put option.
    • For call options: Gamma is positive, indicating that as the underlying asset’s price rises, the delta of the call option increases, making it act more like the underlying asset itself.
    • For put options: Gamma is negative, meaning that as the underlying asset’s price rises, the delta of the put option decreases, making it act less like the underlying asset.
  3. Gamma and Volatility: Gamma tends to be higher for at-the-money options and lower for deep in-the-money or out-of-the-money options. Additionally, gamma tends to be higher for options with more time until expiration. This means that options with high gamma are more sensitive to changes in the underlying asset’s price, especially when they are near the strike price.
  4. Managing Risk: Traders and investors use gamma to assess and manage risk in their options positions. A high gamma position can be riskier because it can experience larger and more rapid changes in delta, which can lead to greater potential gains or losses.
  5. Hedging: Professional options traders often use delta and gamma in combination to create delta-neutral positions. This involves adjusting the position’s delta by buying or selling the underlying asset to offset price movements, effectively eliminating the directional risk associated with the position.
  6. Liquidity: Options with high gamma are often more liquid because they have more significant potential for price changes, which can attract more traders and market makers.

The bottom lines

In summary, gamma is a crucial concept in options trading that measures how sensitive an option’s delta is to changes in the underlying asset’s price. It helps traders assess and manage risk and plays a significant role in constructing and managing options positions. Understanding gamma, along with other Greek letters like delta, theta, and Vega, is essential for effective options trading strategies.

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