What Is Gamma in Investing and How Is It Used?

Gamma (Γ) is an options risk metric that indicates the rate at which an option's delta changes with a one-point movement in the underlying asset's price. Delta measures the change in the option's price for a one-point change in the underlying asset's price. In other words, gamma quantifies the rate of change of delta as the underlying price fluctuates. A higher gamma signifies greater volatility in the option's price relative to changes in the underlying asset's price.

Understanding Gamma

Gamma represents the first derivative of delta and is used to assess how an option’s delta changes with fluctuations in the underlying asset's price. It indicates how delta will adjust as the price of the underlying asset moves. For instance, if an option has a delta of +40 and a gamma of 10, a $1 increase in the underlying price would change the delta to +50.

Gamma is relatively small for options that are deep in or out of the money and reaches its peak for options that are at or near the money. It is also larger for options with shorter expiration times compared to those with longer durations.

Gamma is crucial for understanding the convexity of options pricing and is vital for effective options hedging. For portfolios with significant values, precision in hedging becomes even more critical. In such cases, a third-order derivative called "color" can be used. Color measures the rate of change of gamma and is essential for maintaining a gamma-hedged portfolio.

Why Is Gamma Important to Option Market Makers?

Gamma hedging is designed for traders who are heavily involved in the options market and are looking to manage the complex risks associated with positions that involve nonlinear price exposures. This includes institutional investors, proprietary trading firms, and sophisticated retail traders who seek to fine-tune their risk management practices.

Gamma is crucial for option market makers, whose role involves providing liquidity in the options market. These professionals face substantial and often intricate risks due to rapid changes in delta. Gamma measures this risk, allowing market makers to swiftly adjust their portfolios to maintain balance and ensure their long-term stability in the market.

How Gamma Works and When to Use It?

Gamma hedging involves taking an offsetting position in either the underlying asset or other options to counteract the gamma effect of an existing position. For example, if a trader has options that increase in delta as the stock price rises, they might hedge by purchasing puts or selling calls to counterbalance this increase. This ongoing adjustment helps maintain a delta-neutral position, enabling traders to manage their exposure more effectively amid market fluctuations.

Effective gamma hedging requires a thorough understanding of the underlying assets, precise timing, and accurate calculation of the hedging amount. The process typically starts with identifying call options or other derivatives that are highly sensitive to market changes and volatility. Next, it’s essential to pinpoint the optimal times for entering and exiting these positions, based on a detailed analysis of market trends, option expiration dates, and the deltas of various strike prices.

The timing of these decisions is crucial, as it impacts the success of the gamma hedge in terms of locking in profits or mitigating losses. Additionally, selecting the right number and types of options for hedging involves evaluating potential price movements and associated risks, ensuring that all positions are adequately covered without exposing the portfolio to excessive cost or risk.

When considering shares, indices, forex (foreign exchange) and commodities for trading and price predictions, remember that trading CFDs involves a significant degree of risk and could result in capital loss.

Past performance is not indicative of any future results. This information is provided for informative purposes only and should not be construed to be investment advice.