Note: This article is the 3rd post in our series Understanding Options Greeks.
Options gamma is a measure of the rate of change in the option's delta in response to changes in the price of the underlying stock. It is an important concept for options traders to understand, as it can help them make informed decisions about the risks and potential rewards of their options positions.
In this article, we will provide an overview of options gamma and how it can be used to inform your trading decisions.
What is Options Gamma?
Options gamma is a measure of the rate of change in an option's delta in response to changes in the price of the underlying stock. It is represented by a positive or negative number, and can be helpful for options traders because it allows them to gauge the potential impact of changes in the underlying stock price on their options positions.
For example, consider an option with a delta of 0.5 and a gamma of 0.1. If the underlying stock price increases by $1.00, the option's delta is expected to increase by 0.1, or 10% (0.1 * 0.5 = 0.05). This means that the option's delta would become 0.6, and the option price will change by $0.6 as the underlying stock price goes up $1.
Calculation of Gamma
Gamma is typically expressed as a decimal and is calculated using the Greek letter Gamma (Γ). The formula for calculating gamma is:
Γ = (∂Δ / ∂S) * (1 / S)
where:
- ∂Δ is the change in delta
- ∂S is the change in the underlying asset's price
- S is the current price of the underlying asset
The change in delta (∂Δ) is calculated by taking the difference between the new delta and the old delta as the underlying asset's price changes. The change in the underlying asset's price (∂S) is typically $1.
It is important to note that Gamma is a second derivative of option value with respect to underlying asset price, thus it's also a measure of convexity of option value as well.
Gamma and Delta
Gamma and delta are closely related concepts in options trading. Delta is a measure of the rate of change in an option's price in response to a $1 change in the underlying asset's price. Gamma, as discussed earlier, is a measure of the rate of change in an option's delta in response to a $1 change in the underlying asset's price.
In simple terms, delta represents the rate of change of an option's price as the underlying stock price changes, while gamma represents the rate of change of delta as the underlying stock price changes. A high gamma means that an option's delta will change significantly as the underlying stock price changes, which can have a significant impact on the potential profit or loss of a trade.
Factors that Affect Options Gamma
There are several factors that can affect the value of options gamma, including:
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The price of the underlying stock: Generally, the closer the underlying stock price is to the option's strike price, the higher the option's gamma will be. This is because when the underlying stock is closer to the strike price, there's a greater chance that the option will be in the money, hence the delta would have more room to change.
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The option's expiration date: As an option gets closer to expiration, its gamma will generally decrease. This is because there is less time for the underlying stock price to move in a direction that would make the option more valuable.
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The option's implied volatility: Options with higher implied volatility will generally have higher gamma, as there is a higher probability that the underlying stock price will move in a direction that would make the option more valuable.
Using Options Gamma to Inform Your Trading Decisions
Now that we have a basic understanding of options gamma, let's look at how it can be used to inform your trading decisions.
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Gamma for Hedging: If you are using options to hedge against potential losses in the stock market, high gamma can be beneficial. Because high gamma options are more sensitive to changes in the underlying stock price, they may be better able to protect your portfolio against potential losses.
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Gamma for Speculation: On the other hand, if you are using options to speculate on the direction of stock prices, high gamma options can be risky. Because high gamma options are more sensitive to changes in the underlying stock price, they may be more susceptible to large losses if the stock price moves against you.
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Gamma for Position management: Options with high gamma can be used to your advantage if you're trying to take advantage of small price movements in the underlying stock. However, options with high gamma also tend to be more sensitive to market moves, which can lead to bigger losses if your trade goes wrong. Therefore, it's important to manage your position and adjust them accordingly to minimize your potential losses.
Gamma Scalping
Gamma scalping is a strategy that uses high gamma options to make a profit. It is typically used by market makers or professional traders to make money from the volatility of the market.
The strategy involves buying and selling options with a high gamma in order to profit from the changes in delta that occur as the underlying stock price changes.
This can be a high-risk strategy and requires a deep understanding of options trading, as well as the ability to quickly and accurately assess market conditions in order to make profitable trades.
Gamma is Simple, but Powerful
Understanding gamma, and how it is affected by changes in the underlying stock price, can help traders to make more informed decisions about when to enter and exit trades, and can also help them to develop effective strategies for managing gamma risk.
However, it's important to keep in mind that options trading is a complex and challenging field and requires deep understanding of the underlying mechanics and market conditions, as well as the ability to quickly and accurately assess market conditions in order to make profitable trades.