The Option Greeks - Gamma

What Is Gamma And How Does It Effect Option Prices?

As we have discussed in previous articles, when it comes to options trading there are a lot of terms that one must come to thoroughly understand and grasp in order to try to become successful in the world of options.

Perhaps the most important terms and components of options trading that must be learned are the option greeks.

The four most well known greeks are theta, delta, gamma, and vega.

We covered the basics of delta in a previous article, and here we will outline the basics of gamma.

What Exactly Is Gamma?

Explanations for the greek gamma can range from the very simple to the very complicated.

Gamma is expressed as a number showing the rate that deltas are gained or lost based upon movement in the underlying.

The gamma number will show how delta will change based upon a one point move in the underlying.

The simplest and easiest explanation to grasp for new options investors or traders is that gamma measures how quickly an option's delta might change.

In other words, gamma is the delta of the delta.

Just as an option's delta measures the rate of change of the option's value relative to changes in the underlying instrument, gamma simply measures the rate of change of delta.

Just as deltas are different for options that are in-the-money, at-the-money, or out-of-the-money, gamma rates will differ as well based upon where an option is relative to the underlying instrument's price.

Gamma is highest for at-the-money options while gamma diminishes for in-the-money and out-of-the-money options.

Long options have positive gamma while short options have negative gamma.

This essentially means that an investor that is long gamma may benefit from a move in the underlying that effects gamma while one who is short gamma does not want movement in the underlying.

Options that are closer to expiration have higher rates of gamma than options that have more time until expiration.

Basically, this means that options that are near or at-the-money with little time until expiration have the most "Explosiveness."

It is important to remember that gamma is always changing.

When one is long gamma, their position will become "Longer" as the price of the underlying moves higher and one will become "Shorter" while the price of the underlying falls.

Therefore, one who is long calls will gain more long deltas while the price goes up and hence their position may increase in value while one who is long puts will gain more deltas while the price goes down and hence their position may increase in value.

The opposite holds true for investors who have sold the options or are short.

One who is short gamma will become shorter as the underlying asset rises in price and longer as underlying price falls.

How Do Investors Or Traders Use Gamma?

Like its greek counterpart delta, gamma is used as a risk measurement.

By knowing and monitoring gamma risk, and investor may be able to put on positions in underlying instruments with very precise risk parameters.

Gamma allows one to calculate how a position may behave based upon even very small changes in the underlying asset price.

By understanding and constantly calculating gamma risk, one can also put on portfolio hedges that may be effective over a broader range of underlying price movement.