Understanding Gamma in Options Trading

Options trading can seem complex, filled with Greek letters and jargon. One of these key concepts is “gamma.” Simply put, gamma is about how much an option’s delta will change for every one-point move in the price of the underlying asset. Delta tells us how much an option’s price *should* move for a one-dollar change in the stock price. Gamma, then, is the rate of change of that delta figure. This might sound confusing now, but let’s break it down step-by-step to understand this important factor in options trading.

Delta: The Foundation

Before diving deep into gamma, it’s important to understand delta. Delta indicates how much the price of an option is expected to change for every $1 move in the underlying asset’s price. For example, a call option with a delta of 0.50 means that for every $1 increase in the underlying stock’s price, the call option’s price could theoretically increase by $0.50. A delta of 1 is rare, and it means the change in the option will exactly match the underlying asset. A delta of 0 means the option won’t move much at all with the underlying asset.

  • Call options generally have positive deltas (between 0 and 1).
  • Put options generally have negative deltas (between -1 and 0).
  • A delta closer to 1 for a call option, or -1 for a put option means the option behaves more like the underlying stock.
  • A delta closer to 0 means price changes in the option will be less significant than price changes in the underlying asset.

What is Gamma?

Now, let’s talk about gamma. Gamma measures the rate of change of delta. Think of it like acceleration in a car. Delta is the speed at which your car is travelling, and gamma is how quickly that speed is increasing or decreasing. If an option has a gamma of 0.10, it means that for every $1 move in the underlying stock price, the option’s delta will change by 0.10. Delta is always changing, so gamma tells us how fast the delta is changing.

For example, suppose a call option has a delta of 0.40 and a gamma of 0.10. If the underlying price goes up by $1, the delta might increase to 0.50. If the stock rises another dollar, the delta will likely rise to 0.60. It’s not a perfect linear relationship, but that’s the idea. High gamma means delta is changing very quickly, low gamma means delta is changing very slowly.

Key Attributes of Gamma

Gamma has several important characteristics that traders should be aware of:

  • Positive Value: Gamma is nearly always a positive value (exceptions are very rare).
  • Maximum at the Money: Gamma is highest when an option is at-the-money (ATM), meaning the strike price is close to the current price of the underlying asset. This is when delta is changing most rapidly.
  • Decreases as Options Move In and Out of the Money: As an option becomes more in-the-money (ITM) or further out-of-the-money (OTM), its gamma decreases. This means Delta is likely to remain stable.
  • Higher for Shorter Time to Expiry: Gamma is higher as the option’s expiration date approaches. This makes it harder to predict price movements of near expiring options.

These features mean that options near expiration and near the price of the underlying asset are particularly sensitive to price changes in the stock.

How Traders Use Gamma

Traders use gamma in several ways to manage risk and make trading decisions:

  • Gamma Scalping: A popular but advanced strategy, traders may try to profit from rapidly changing prices on options with high gamma. The approach focuses on small gains made from these short but fast price movements. This strategy requires good trading software and expertise since prices can move rapidly and not always as expected.
  • Hedging: Gamma can be used as a risk measure. It indicates how exposed a portfolio is to price changes in the underlying asset. If you know the gamma profile of your options, you can manage positions to reduce risk or expose yourself to more volatile movements.
  • Understanding Options Sensitivity: By paying attention to gamma, traders get a better understanding of how sensitive their options positions will be to changes in the stock price. This makes sure you have a better understanding of the possible risks and rewards of each trade.

Gamma and Time Decay

Time decay, often represented by the option Greek theta, impacts an option’s price as it gets closer to its expiration date. Gamma and theta are often related. A higher gamma option closer to expiry will also have a higher rate of time decay. This means as the option reaches its expiry it may become less valuable. Understanding the interplay between time decay, delta and gamma, is important for accurately evaluating an option’s potential for profit and loss.

Gamma vs. Delta

Delta and gamma are often used together. However, they measure different things. Delta measures the current price sensitivity of an option, but gamma measures the rate at which that sensitivity will change. Delta gives you the estimated impact of a dollar move in the stock price, and gamma tells you how much *that impact* will change with every dollar move in the stock.

Practical Example

Let’s imagine you own a call option on a stock trading at $100. The option has a delta of 0.40 and a gamma of 0.05.

  • If the stock rises to $101, the option price might go up by $0.40 (delta’s influence) and the delta might increase to 0.45.
  • If the stock rises to $102, the option price might go up an *additional* $0.45 (the new delta’s influence), and the new delta might increase again to 0.50.

This illustrates how gamma describes how the price responsiveness of an option is changing in relation to the stock price changes.

Risks of High Gamma

While high gamma can offer opportunities for profit, it also comes with increased risk. Options with high gamma can experience rapid and unpredictable price changes. This is particularly relevant when an option is close to expiry, because a change in delta can significantly impact the value of the option quickly. When dealing with higher gamma, traders need to be ready to react very quickly because prices can move against the trade unexpectedly.

Conclusion

Gamma is a critical yet often misunderstood concept in options trading. It allows for an understanding of how rapidly the price responsiveness of an option can change, making it an essential consideration for managing risk and assessing potential profit. By combining a solid understanding of delta and gamma, you can better manage the potential risks and rewards that come with trading options, and develop more effective trading strategies.

FAQ

What is a good gamma value?

There isn’t a “good” gamma value in a general sense. It depends on your strategy, risk appetite, distance to expiration and the specific market conditions. Higher gamma means higher risk but potentially higher reward.
Can gamma be negative?

No, gamma is almost always positive. An option seller would generally want their options to have as low of a gamma as possible.
How is gamma useful in options trading?

Gamma helps you understand the potential volatility of an option’s price; it measures the rate of change of delta. Traders use it for risk management, hedging strategies and gamma scalping.
Is gamma a standalone indicator?

No, gamma is best used in conjunction with other options Greeks (delta, theta, vega) and market analysis techniques. Relying solely on gamma can expose you to risks.
Does more time to expiry increase an option’s Gamma?

No, it is the opposite. Options with a longer time to expiration will have a lower gamma. More decay (theta) comes with higher gamma.

References

  • Hull, J. C. (2018). Options, Futures, and Other Derivatives. Pearson.
  • Natenberg, S. (2015). Option Volatility and Pricing. McGraw Hill.
  • Epps, B., & Wahlen, J. (2018). Option Trader’s Hedge Fund. John Wiley & Sons.

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