Gamma has a variety of understandings. It could mean the third letter of the Greek alphabet (but Gamma options are not necessarily Greek). It has been used in science and particularly in physics. Bet you didn’t know (despite all your photo editing) that Gamma is also the degree of contrast achieved in a photo or video.
We’re not here to talk about Gamma in any of those contexts, of course, but Gamma in the trading context, and specifically Gamma with regards to Futures and Options.
What is the meaning of Gamma?
Gamma – in options trading – refers to the rate of change in an option’s Delta (we will explain this too below) linked to per-point movement in the underlying asset’s price.
Example to understand Gamma in options trading
Let’s say that Mohan weighs 100 kgs and wants to lose 40 kgs. For every 1 hour that Mohan jogs, he loses half a kg. The rate of weight change per kg jogged is 500 gms/ half kg.
- The rate of Mohan’s weight change can be equated to the Delta – not the gamma – of an option (or the rate of option price change) that is 500 gms per hour.
- However, after Mohan exercises for a month, his metabolism goes up and he starts losing 750 gms per hour. The difference between the earlier rate of weight loss per hour and the current rate of weight loss per hour can be compared to Gamma. Gamma is the Delta of Delta or the rate at which the rate change occurs. So, the rate at which his rate of weight change, changes, can be likened to gamma.
- 1 kg might be likened to say Rs 1 or Paise 1 change in the underlying asset’s price.
- And Mohan’s current weight can be likened to the present price of the asset or the stock.
Another very common analogy used to explain Gamma comes from Physics, where Delta is compared to speed and Gamma is compared to acceleration.
Gamma calculation example
Step 1: Let us assume that we are tracking a call option for a stock that as of this morning had a delta of 0.3.
Step 2: As the day progressed, the stock price increased by Rs 1, and the option too increased in value by 30 paise or Rs 0.30.
At this point, the delta will also change. Let’s assume that after the Rs 1 stock price increase, the option’s delta is now 0.62.
Step 3: The difference of Rs 0.32 in the deltas is the approximate value of gamma.
This admittedly sounds very simple here, but we have used a high level of abstraction and simplicity for this example. Consider how stock prices fluctuating by the second and option prices fluctuating by the second (and consequently delta and Gamma fluctuating by the second) might make for quite a challenge.
- While talking about Gamma trading, the concepts of Delta and Alpha are also likely to arise. We have explained Delta above; Alpha refers to a rate of return that beats the market.
- ITM, OTM and ATM are also relevant in Gamma discussions:
- Call Options are said to be In the Money (ITM) when the current stock price is higher than the strike price of the options contract; Out of the Money (OTM) refers to the opposite and At the Money (ATM) is when both values are equal.
- On the other hand, Put Options are ITM when the strike price is higher than the ongoing stock price (and the rest follows suit).
Fundamentals of Gamma options
- When options are ITM of OTM, gamma is typically small (Gamma is either small or big, not low or high like a stock price).
- When options are ATM, gamma is usually large.
- Negative gamma is characteristic to short position options.
- Positive gamma occurs in options with a long position.
Benefits of using Gamma in trading
- Gamma can be effective in risk management and predictions. It is used as a hedging strategy and is especially useful to portfolio managers and traders who work with very large amounts of capital that require a certain level of precision.
- Gamma also asks as a base for other derivative metrics. Gamma is derived from Delta and acts as a metric for enabling predictions about option price movement. Similarly, another derivative metric called “colour” is derived from gamma.
- Gamma can help portfolio managers and traders achieve an amazing level of precision in their predictions.
Considerations when using Gamma in trading
- The calculation of Gamma (as you may have imagined when we called it the delta of the delta) is rather complex.
- It also requires investment in dedicated software or dedicated tools.
- Precision in predicting the rate at which the Delta of an underlying asset will change is the main draw of Gamma calculations, so unless you are hedging using Delta, it is not exactly useful.
- This level of precision is extremely useful for the management of very large investments and portfolios. Beginner traders might be able to get by observing candlestick patterns and learning to use technical indicators.
Although gamma ushers in a great level of precision on making option price predictions, investors must hone options trading experience to use it effectively. Gamma is an excellent go-to if you are managing a large portfolio.