Finance Gamma Greek - Financial Business

Gamma: Understanding the Greek

Gamma is one of the “Greeks,” a set of measurements used in options trading to describe the sensitivity of an option’s price to changes in underlying asset price. Specifically, gamma measures the rate of change of an option’s delta for a one-point move in the underlying asset’s price. In simpler terms, it tells you how much the option’s delta will change if the underlying asset price goes up or down by a dollar.

Gamma is always positive for both call and put options. This is because as the underlying asset price moves further into the money, the delta of the option increases, regardless of whether it’s a call or a put. Think of it this way: an option deep in the money behaves more and more like the underlying asset itself, thus approaching a delta of 1 (for calls) or -1 (for puts). Conversely, options far out of the money behave less and less like the underlying asset, approaching a delta of 0.

A high gamma indicates that the option’s delta is very sensitive to changes in the underlying asset price. This means the option’s price will fluctuate more rapidly as the underlying asset moves. Options with high gamma are generally closer to at-the-money (ATM) because this is where the delta is most sensitive. Conversely, a low gamma indicates that the option’s delta is less sensitive, meaning the option’s price will be more stable relative to the underlying asset.

Understanding gamma is crucial for options traders because it provides insight into the stability of their hedge. If a trader is delta-hedged (meaning they have neutralized their exposure to the direction of the underlying asset), a significant change in the underlying asset’s price can quickly render that hedge ineffective due to gamma. This is known as gamma risk.

Gamma is directly related to the time until expiration and volatility. Options closer to expiration generally have higher gamma, especially those near the strike price, as the delta can change dramatically in the final days or weeks. Higher volatility also tends to increase gamma because it increases the likelihood of the underlying asset price making significant moves. Time decay (theta) also impacts gamma. Generally, gamma will increase as expiration approaches, and then decrease dramatically right before expiration as the option’s payoff becomes binary (either in the money or out of the money).

Traders use gamma in several ways:

Assessing risk: Gamma helps traders understand the potential exposure to changes in the underlying asset’s price.
Dynamic hedging: Gamma helps traders adjust their hedges to maintain a neutral position as the underlying asset price moves. This often involves rebalancing their portfolio by buying or selling the underlying asset or other options.
Volatility trading: Gamma can be used to profit from expected changes in volatility. Strategies like gamma scalping aim to capture small profits from changes in the option’s price as the underlying asset price fluctuates.

In summary, gamma is a vital tool for options traders, providing crucial information about the sensitivity of an option’s delta. While understanding gamma can seem complex, mastering this Greek is essential for effectively managing risk and maximizing potential profits in options trading.