Gamma in trading definition

What is gamma in trading?

Gamma is a term used in options trading to represent the rate of change in the option’s delta. While delta measures the rate of change in an option’s price compared to the underlying asset, gamma measures the rate of change in an option’s delta over time.

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Delta is constantly changing, and it shows how the price of an options contract changes after a $1 increase or decrease in price of the underlying market. Gamma on the other hand, is used to understand the change in delta, and to attempt to forecast future price movements in the underlying. Options with a high gamma will be more responsive to changes in the price of the underlying asset when compared to options with a low gamma.

When trading options, gamma is always at its largest when an options contract is at the money because these options can quickly shift to being in the money or out of the money. Gamma is at its smallest when an options contract is comfortably in the money or out of the money, because the likelihood of these options changing dramatically in value is greatly reduced. Gamma will always be positive for long options and it will always be negative for short options.

Example of gamma

As gamma is extremely complicated to calculate, most traders will use spreadsheets and specialist software. For the purpose of this example, we will work from some simplified assumptions about the changes in the value of gamma.

Suppose an underlying asset is trading at $50, and its option has a delta of 0.3 and a gamma of 0.2. The gamma of an option is often represented as a percentage.

In this example, for every 20% move in the stock’s price the delta will be adjusted by a corresponding 20%. This means that a $1 increase in the price of the underlying will cause the delta to increase to 0.5 – by adding the gamma of 0.2 to the current delta of 0.3.

Similarly, a 20% decrease in the price of the underlying will result in corresponding decline in delta to 0.1 – by subtracting the gamma of 0.2 from the current delta of 0.3.

Gamma hedging strategy

A gamma hedging strategy can be used to reduce your exposure to risk in an options contract. You’d use it if the underlying market makes strong up or down moves contrary to your current options position, as the expiry date of the contract approaches.

For example, if you had a profitable position on a number of calls and the expiry date was approaching, you could take out a smaller position using put options. This would help to protect you against any unexpected price drops in the short timeframe before the call options reached their expiry.

You could do the same thing for a put option position. If the price of the put options you held had fallen below the strike price, meaning they’re profitable, you could take out a smaller call option position. This could help to protect you against any possible increases in price as the expiry date of the put options approached.

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