What Is Gamma and How Is It Used in Investing?

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Gamma: What Is It?

The rate at which an option’s delta changes for every one-point change in the underlying asset price is measured by the options risk statistic known as Gamma (). The term “delta” describes how much an option’s premium (price) will vary if the underlying asset’s price moves by one point. Gamma is a measurement of the pace at which the price of an option will fluctuate in response to changes in the underlying price. The price of the option is more volatile the greater the Gamma.

Gamma is a crucial indicator of how convex a derivative’s value is compared to its underlying asset. In addition to delta, rho, theta, and vega, it is one of the “options Greeks.” These are employed to evaluate the various risk categories in option portfolios.

Key Concepts

  • Gamma is the percentage change in an option’s delta based on a change of one point in the price of the delta.
  • It is a risk factor of the second order, sometimes referred to as the delta of the delta.
  • When an option is in the money, its gamma value is highest; when it is farther from the money, its gamma value is lowest.
  • Gamma is also higher, on average, for options that are less distant from expiry than for those that are more distant.
  • Gamma is employed when attempting to predict how changes in the underlying asset would impact an option’s moneyness.
  • An options position is protected against changes in the underlying asset via delta-gamma hedging.

Understanding Gamma

Gamma, the first derivative of the delta, is used to estimate how much an option will change in price, whether in the money or out of the money. It details how the differential will alter when the value of the underlying asset changes. Therefore, if the Gamma is ten and the Gamma of an option is +40, a $1 increase in the underlying price would cause the option’s delta to climb to +50.

Gamma is tiny when the assessed option is far in or far out of the money. Gamma is at its highest value when the option is close to or at the money. Gamma is higher for options with near-term expirations than options with longer dates.

Gamma is a crucial statistic since it considers convexity problems when using options hedging methods.

1 Some traders or portfolio managers may deal with portfolios with such high values that even greater accuracy is required while hedging. “Color” is a third-order derivative that may be applied. Color measures the gamma change rate for the maintenance of a gamma-hedged portfolio.

In physics, an option’s delta represents its “speed,” but its Gamma represents its “acceleration.”

How Does Gamma Work?

Gamma gives traders a more accurate picture of how the option’s delta will fluctuate over time when the underlying price changes. An option’s delta measure is only valid for a brief period. The delta factor measures how much the option price shifts in response to changes in the underlying asset’s value.

As an option moves more into the money and the delta goes closer to one, the Gamma declines, eventually reaching zero. Gamma also comes closer to zero, the more out of the money an option is. Gamma is at its greatest level when the price is in the money.

Gamma is difficult to calculate accurately without using spreadsheets or financial tools. The following, however, shows how to calculate Gamma roughly. Consider a call option with a delta of 0.40 on the underlying stock. The option’s value will rise by 40 cents, and its delta will alter if the stock’s price rises by $1.00. Assume the option’s delta is now 0.53 after the $1 rise. It is possible to use the 0.13 delta difference as a rough estimate of Gamma.

The Gamma of all long options is positive, whereas the Gamma of all short options is negative.

Gamma Example

Stock trades at $10, and the option’s delta and Gamma are both 0.10. The delta will then be modified by a matching 0.10 for each $1 movement in the stock’s price. As a result, an increase of $1.00 will increase the option’s delta to 0.60. In the same way, a $1.00 reduction will cause the differential to drop to 0.40.

Gamma Hedging: How Do Traders Do It?

Gamma hedging is a tactic that seeks to keep the delta in an options position constant. This is accomplished by strategically purchasing and selling options to balance one another out and provide a net gamma of just about zero. The situation is referred to as being gamma-neutral at this moment. A trader will frequently also wish to have zero gammas around a delta-neutral (zero-delta) position. This is accomplished by using delta-gamma hedging, where net delta and net gamma are both near zero. In this scenario, the value of an options position is protected against fluctuations in the underlying asset’s price.

A Long Gamma Strategy is what?

If traders are long Gamma, price changes in the underlying asset cause the delta of their options position to grow. For instance, if the underlying price increases, a long gamma position will experience ever-increasing deltas, or ever-decreasing deltas, as the price declines. By encouraging the trader to purchase low and sell high regularly, long-gamma exposure can result in net gains if the trader can sell deltas as prices increase and then buy deltas as prices fall.

Gamma Risk: What Is It?

There is a chance that price changes in the underlying will result in compounding losses for short gamma options bets. For instance, if the stock increases and the position starts with a delta-neutral delta, the position will yield more short deltas, which means that as the underlying rises, the options will lose money. However, there is a danger that if the deltas are purchased at these steadily increasing prices, the underlying asset may reverse course and decline, producing long deltas down and compounding those previous losses.

The Conclusion

Gamma calculates how quickly the delta changes with an increase of one point in the underlying asset. It is a useful tool for forecasting changes in the delta of an option or a position as a whole. Gamma will be higher for options at the money and gradually smaller for options both in and out of the money. In contrast to Delta, Gamma is always positive when both calls and puts are long.

Investopedia does not offer tax, investment, and financial services. The material is provided without considering any individual investor’s investing goals, risk tolerance, or financial situation, so it might not be appropriate for all investors. Risks associated with investing include the potential loss of investment.

References

What Is Gamma in Investing and How Is It Used? – Investopedia. https://www.investopedia.com/terms/g/gamma.asp

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