Option Gamma
The gamma of an option indicates how the delta of an option will change relative to a 1 point move in the underlying asset. In other words, the Gamma shows the option delta's sensitivity to market price changes.
Gamma is important because it shows us how fast our position delta will change as the market price of the underlying asset changes.
Remember: One of the things the delta of an option tells us is effectively how many underlying contracts we are long/short. So, the Gamma is telling us how fast our "effective" underlying position will change.
In other words, Gamma shows how volatile an option is relative to movements in the underlying asset. So, by watching your gamma will let you know how large your delta (position risk) changes.
The above graph shows Gamma vs Underlying price for 3 different strike prices. You can see that Gamma increases as the option moves from being in-the-money reaching its peak when the option is at-the-money. Then as the option moves out-of-the-money the Gamma then decreases.
Note: The Gamma value is the same for calls as for puts. If you are long a call or a put, the gamma will be a positive number. If you are short a call or a put, the gamma will be a negative number.
When you are "long gamma", your position will become "longer" as the price of the underlying asset increases and "shorter" as the underlying price decreases.
Conversely, if you sell options, and are therefore "short gamma", your position will become shorter as the underlying price increases and longer as the underlying decreases.
This is an important distinction to make between being long or short options - both calls and puts. That is, when you are long an option (long gamma) you want the market to move. As the underlying price increases, you become longer, which reinforces your newly long position.
If being "long gamma" means you want movements in the underlying asset, then being "short gamma" means that you do not want the price of the underlying asset to move.
A short gamma position will become shorter as the price of the underlying asset increases. As the market rallies, you are effectively selling more and more of the underlying asset as the delta becomes more negative.
Long Gamma Trading
Take a look at this video from Options Unversity. It provides an overview of the concept of Gamma Trading.
Source: Options University.
The above video is an expert from OU's Options101 Home Study Course.
Comments (8)
sam
July 28th, 2010 at 9:06pm
you are right. delta of put is decreasing function from -1 to 0 as the stock price increases. I was thinking in terms of absolute value of delta...
Peter
July 28th, 2010 at 6:10pm
Hi Sam, it's a good question. You have to remember that a put's delta is negative so with a positive gamma and an increasing stock price the delta of a put becomes less negative - or "longer". The more the stock rallies the closer the put's delta approaches zero as more gamma is added to it.
Call options, with a positive delta and positive gamma will also "get longer" as the stock price rises. The higher the stock moves away from the strike price the closer the call option's delta approaches 1.
sam
July 28th, 2010 at 4:14pm
May be I am missing something. Mathematically, gamma is always positive for both call and put.
But as the stock price increases, shouldn't the put have negative gamma as the graph of put delta vs stock price is decreasing? Please someone clarify
Seth Baker
February 9th, 2010 at 3:04pm
This is interesting stuff. I use google to help me find stuff about options. One cool site has a different approach - they claim to not have an opinion on the market. Rather, they work with you on which type of trade to make, based on the Greeks, etc. I may spell this wrong, but I think it's http://www.timeforoptions.com
Peter
October 8th, 2009 at 7:05pm
Hi Anthony, I agree that the video doesn't get off to a good start...I link directly to the video on the OU site. They've changed the video to what they've had previously, which provided a longer introduction.
At the start of the video Ron has already begun discussing "short gamma", where if you are short gamma and the market is going down your position gets "longer" i.e. your delta position grows. That's what he means when he says "buying deltas" on the way down.
Do you think my description (not the video) above differs from what you've read elsewhere? If so, let me know where the contradiction is and if I'm wrong I'll correct the content accordingly.
Thanks for the feedback!
Anthony
October 7th, 2009 at 10:39pm
I am learning to trade options by the greeks (delta, gamma, theta, vega) but have traded options for many years. I have looked up several definitions and am doing an online course. This definition here and the subsequent video are by far the most confusing I have ever come across. The video begins with "In a sense on the way down, our short gamma position is buying deltas for us...". How in the heck can someone trying to understand Gamma as a definition begin to understand this.
Peter
September 20th, 2009 at 8:09pm
Thanks for the suggestion...much appreciated. I'll write up something on delta neutral trading and a bit more on gamma scalping.
Howdy
September 20th, 2009 at 10:38am
I have basic knowledge of options buying and selling calls and puts.
I would appreciate it if more detailed explanation is added in for gamma and delta trading. I am still confused as to how gamma trading works.
Thanks
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