In options trading, the term Gamma represents the rate of change in the option’s Delta. Similarly, the term Delta measures the rate of change in an options price with respect to the underlying asset.
But where does Gamma come from, how is it used in underlying stocks, and Gamma’s hedging strategy? Read this post to get the answer.
What is Gamma?
Gamma is a term used to represent the rate of change between the option’s Delta and the underlying asset’s price. If the Gamma value is high, even a small price change in the underlying stock or fund could change the Delta.
As Delta shows how options contract price changes after a $1 decrease or increase in the underlying market price, it constantly changes. In contrast, the term Gamma is used to understand any change in Delta. It can also be used to predict price movements in the underlying.
Options with high Gamma are more responsive to underlying asset price change than options with low Gamma. Since the Delta of at-the-money options immediately reacts to underlying price changes, they have high Gamma.
Let’s assume the market price of ABC is $200. So, ABC $200 is supposed to be at-the-money. But if the price moves in any direction, it would send the contract out of the money or in-the-money. It indicates that the contract is sensitive to underlying stock movement. For this reason, Gamma is higher.
Similarly, if the option is near-the-money, Gamma increases as expiry approaches. It happens because the time value is depleting. As a result, the option loses its extrinsic value and retains its intrinsic value. In this situation, the Gamma is known to calculate Delta, and the Delta calculates the intrinsic value.
The options at their expiration are priced in the intrinsic value. Thus, Delta is known to have sudden and large moves when expiration is around. It moves between close to 0 and close to 1 or -1. This movement is reflected in high Gamma.
Usually, it’s believed that higher Gamma indicates a higher change in Delta. It means higher movement in the option’s price. One thing to bear in mind is that Gamma is a positive value for long options, and for short options, it’s a negative value.
Example of Gamma
Calculating Gamma is not easy. In fact, many traders use spreadsheets and special software.
Let’s assume, at $50, an underlying asset is traded. The option of this asset has a Gamma of 0.2 (Gamma of option is represented in percentage) and Delta of 0.3.
So, Delta will be adjusted by 20% for every 20% move in the stock’s price. That means if the price of the underlying asset moves by $1, the Delta will increase to 0.5, and the Gamma will move to 0.3. But if there is a decrease in the underlying asset price by 20%, the Delta will decline to 0.1.
Where Does Gamma Come From?
Let’s assume a delta of 0.8 means for each US dollar the stock moves, and a change in the option premium will occur by 0.8.
In short, Delta shows how much market makers need to hedge. The below example will clear the true role of the Delta.
Imagine a situation where the market maker is short by selling 2000 call contracts at a strike price of $12. And the stock of this contract is currently trading at $8. The strike price is above stock. That means the market is good to go.
In this situation, the Delta can be somewhere between 0 to 0.1. Thus, the market does not have to hedge at all.
However, with a rise in underlying stock price, Delta can approach 0.5 at the strike price. Here, they can measure this change. To deal with this situation, the market maker must buy more stock to adequately hedge.
For example, a delta of 0.5 has a 50% expiration chance of in-the-money. So, when the market is at the strike price, market makers have a half-half chance of whether the call will expire above the strike price or not.
But if the price keeps increasing, the Delta will also increase and reach 1. In this situation, the whole option must be hedged.
How to Calculate Gamma?
Professional option sellers use sophisticated models to determine how to price their options. The model usually resembles the Black-Scholes model. It’s a mathematical equation that considers the impact of time and other risk factors to estimate the theoretical value of options.
The formula for calculating Gamma is (D1 – D2) / (P1 – P2).
D1 is the first Delta, and D2 is the second Delta. Similarly, P1 is the underlying stock’s first price, and P2 is the second price of the underlying stock.
Let’s assume the stock ABC is trading at $100 per share. $100 call options for the stock is believed to have a delta of 0.3. So, when the underlying stock price rises by $110 per share, the $100 call option’s delta increases to 0.5. Here’s how you can calculate Gamma:
- Gamma = (0.3 – 0.5) / ($100 – $110)
- Gamma = (-0.2) / (-10)
- Gamma = 0.02
Since a computer algorithm calculates Gamma in real-time, it is readily accessible via many registered broker dealer.
How is Gamma Used for Underlying Assets?
Gamma can be used in different ways. Below are three of the best ones:
The Stability of Delta
You can use Gamma to measure Delta’s stability or instability. If the Gamma value is high, the Delta value might change. Therefore, the Delta is unstable. Knowing the stability comes in handy when you use Delta for being in-the-money at expiration.
Long Options and Gamma
As you know, Gamma is used to describe the movement in Delta, and Delta helps in knowing the option’s sensitivity to underlying assets. That means you can use Gamma to understand the change in the option’s price.
If the Gamma value is high, the option value has accelerated with the underlying stock price moving up or down by $1. This thing accelerates the profits and losses for long positions.
Short Options and Gamma
Since options go through accelerated movement, higher Gamma can be risky for options sellers. Higher Gamma means accelerated movement of the underlying stock.
What Other Factors To Consider For Underlying Stock?
Gamma usually goes to 0 when Delta has reached out-of-the-money or in-the-money at expiration. If the Delta is 0 at expiration, the option is worthless as the market price is better. But you can trade a Delta of +1 / -1 at expiration as it is better than the market.
Options deep in-the-money have Delta extremely close to either +1 or -1. Here, Gamma is not that strong. For this reason, Gamma is higher for options at-the-money.
With an increase in the Gamma, there comes a decrease in the cost of owning an option (Theta). The Theta is known to calculate an option’s expected rate of decline over time. Since options lose their time value near expiration, Theta is prevalent.
When is Gamma Active?
As an options trader, one needs to know when Gamma is active. Well, Gamma is high only near expiration. Thus, there will be the higher risk in the expiry week. It happens because there remains very less time for a reversal. So, if you want to earn a profit from Gamma trade, you can trade during the expiry week.
How does Gamma Squeeze Occur?
In a general situation, Gamma takes place in a short space of time with high trading volumes in one direction. As a result, the market maker raises the share price by existing their position.
Here, the trade is heavily influenced by world news and trader sentiments. What happens is that when the big financial news breaks, it results in larger than usual trade volume in a certain direction.
Surely, the high market volume helps successful traders earn a good amount of money, but it’s not a good sign for market makers. High volume can force market makers out of their position.
And when the market makers sell or buy their position, it puts pressure on the strike price. In this situation, the market maker tries to mitigate risk wherever possible.
In short, Gamma occurs when there is widespread speculation about the stock price’s direction.
What is Gamma Hedging Investment Strategy
Traders try to decrease the risk in an options contract through Gamma hedging trading strategy. This strategy comes in handy when the underlying market is making strong down moves or up moves with respect to the current position as the expiry date approaches.
Let’s assume that the expiry date is approaching and you have a profitable position on a number of calls. Using put options, you can use smaller positions. Doing this will keep you safe when there’s an unexpected price drop before the call option reaches expiry.
It can also be done for a put option position. Suppose the put option price had fallen below the strike price; it is believed to be profitable. In this case, you can take out a smaller call option position.
How to Use Gamma in Real Trading?
The Gamma is the highest when the strike price is close to the stock price. In this situation, there’s maximum impact on the Delta. When the option becomes deep on-the-money or in-the-money, the impact on Delta decreases.
Suppose the stock price of an underlying asset is $850, and it has an out-of-the-money 870 that is available at $18. The Delta value of this stock is 0.4, and Gamma is 0.1. So, what will happen if the price moves from $850 to $880?
As Delta has a value of 0.4, the call option price will move by 0.4 x (30). As a result, the 870 call option price will increase by $12 from $18. As far as Delta is concerned, it will move up by the extent of Gamma.
Considerations When Using Gamma In Trading
As you know, the calculation of Gamma is complex; you need to be careful. Successful Gamma trading requires investment in dedicated tools and software. Tools and software offer precision in speculating the rate at which the underlying asset’s Delta will change its price.
Better precision is useful for large investments. If you are a beginner trader, you should also learn to use technical indicators and observe candlestick patterns.
How to Trade Gamma?
If you wish to trade gamma, you should have a high tolerance level. Also, it’s important to remember that no two gamma squeezes are similar as complexity arises in the situation.
At certain times, you will notice sharp peaks and frequent price changes, and others will become weaker over time.
If you want to gamma squeeze trading, you must understand timing. That’s because if, as a trader, you are not able to identify gamma squeeze and trade accordingly, you will lose a huge amount of money. Also, it’s necessary to have a fast and responsive trading platform.
While trading gamma, you need to look at two factors:
- High Short-Stock Interest: If you want a squeeze to happen, you need traders who become stuck. That means you need a stubborn, short trader.
- Options Activity: Options are also important because there is less market movement when the traders play options. As a result, there remain few positions to squeeze.
Frequently Asked Questions
How to use Gamma to trade underlying stock prices?
Depending on whether your option is long or short, you can use Gamma. The Gamma stays negative if you are short on the put or call option. But in the opposite situation, Gamma will be positive.
How Gamma and volatility are related to strike price?
If the implied volatility increases, the Gamma of in-the-money and out-of-the-money calls and puts decreases. But if the implied volatility decreases, the Gamma of at the money calls and puts increases.
Is higher Gamma good?
Higher Gamma is known to increase the risk for traders because the option experiences accelerated movement.
What is negative gamma?
If there is long gamma, you can conclude that in case of price fall, the Delta of a long put might move towards 1.00 and become more negative. Here, in case of a price rise, it will move towards 0 and become less negative.
Gamma in options trading represents the rate of change in the option’s Delta. Traders who want to manage a large portfolio must know how to calculate Gamma and limit its risks.