Gamma is a useful option Greeks measure that helps you determine the rate of change of an option’s Delta when the price of the underlying security moves. Therefore, it is a very helpful measure just like other Greeks measures. In fact, understanding the different risk dimensions associated with options trading empowers you to make accurate trading decisions.
Having said that, it is important to learn all about Gamma and how it helps in options trading. If you want to know about this useful measure, then you are on the right platform. In this article, we are going to define and explain Gamma in the easiest terms. So, let’s begin right away.
Gamma is an option Greeks measure that measures the rate of change in Delta over time. It tells traders and investors about the change in the Delta value of an option when the price of the underlying security moves by $1. The gamma value ranges between 0 and 1 (-1). Whereas, Delta refers to the sensitivity of an option’s value to the change in the price of the underlying security.
The value of options contracts is sensitive to various factors. Option Greeks measures are calculations that help traders and investors measure their sensitivity to these factors. There are five major option Greeks measures; Delta, Gamma, Theta, Vega, and Rho. Now, Gamma is a measure that tells you how much Delta value changes with a change in the price of the underlying security. So, we can say that it actually keeps tabs on another options Greeks value Delta. Delta is the sensitivity of an option’s value to the change in the price of the underlying security. It is fair to say that understanding Delta is a prerequisite to understanding Gamma.
Delta is an option Greeks measures that tell traders about the sensitivity of an option’s value to change in the price of the underlying security. It helps traders predict or forecast the options’ values based on the price fluctuations of securities. As stock prices change regularly, Delta’s value also keeps on changing. That’s why Gamma is an important measure because it measures the rate of change of Delta and its impact on an option’s value. In simple words, analogically, if Delta is the measure of speed then Gamma is the measure of acceleration or deceleration.
Now, let’s try to understand Gamma values. Gamma values can be both positive and negative. It depends on the type of option as well as whether you are buying or selling. Long positions have always positive Gamma values irrespective of put or call. Conversely, short positions have always negative Gamma values. Long calls and long puts have a value between 0 and 1 while short calls and short puts have a value between -1 and 0.
The next step is how to read those Gamma values. Typically, positive Gamma values for a long call indicate positive Delta when the stock price increases and less positive when the stock price decreases. Conversely, positive Gamma for a long put indicates negative Delta when the stock price falls and less negative when the stock price rises.
Additionally, the state of options contracts also plays a key role in Gamma values. For instance, Gamma values are comparatively low when the spot price of the underlying security is far from the strike price. However, when the spot price moves closer to the strike price, the value begins to rise. As Delta increases when the expiration date comes closer, the Gamma value also rises. That is why the Gamma value is the highest for at-the-money options and options near the expiration date. Contrarily, in-the-money or out-of-the-money options have lower Gamma which indicates very minimal Delta movement.
Finally, a very pertinent question arises and that is how to calculate Gamma. Gamma value calculation is a complex calculation and computer algorithms perform such tasks in real time.
How to hedge against Gamma sensitivity?
There are ways to reduce the risk associated with the Gamma sensitivity of an option contract. An unexpected upward or downward movement of the price upon the expiration date causes significant losses. To hedge against these risks, you can use an offsetting strategy. For instance, you are holding a number of call options and you are in a profitable position. Now, how will you protect your portfolio against an unexpected downward movement? You can take a smaller position by buying put options. It will hedge your original call position against any fall in prices in the short term. Conversely, if you are holding a number of put options and you are in a profitable position. Now, how will you protect your portfolio against an unexpected upward movement? You can take a smaller position by buying call options. It will hedge your original put position against any rise in prices in the short term. Simply put, you can hedge against the put option’s Gamma sensitivity with call options and vice versa.