BAJAJ BROKING
June 13, 2024
4 mins read
‘What is Gamma in options trading?’ is a question that many traders often ask and when they learn that it’s a trading strategy that can make trades potentially profitable, they want to learn about it. The strategy is worth knowing as its components play key roles in risk management and pricing in options contracts.
Gamma is a term with various meanings across disciplines—from physics and photography to mathematics. In options trading, however, Gamma has a specific function. It is one of the key Option Greeks, which are mathematical tools used to assess how option prices respond to changes in market variables.
While Delta measures how much an option’s price is expected to move with a ₹1 change in the price of the underlying asset, Gamma goes a level deeper. It measures how much Delta itself changes when the underlying price moves. In other words, Gamma helps quantify how sensitive Delta is to price fluctuations in the underlying security.
This article explores what Gamma means in options trading, how it is calculated, and how it relates to other market variables such as Delta. It also illustrates Gamma’s behaviour through examples and outlines key associated concepts.
Significantly, options trading strategies use some letters of the Greek alphabet, fondly referred to as ‘Greeks’ in the world of trading and investing in options contracts. If you are an investor who is wondering, “What is Gamma?” in options trading, look no further as this blog will tell you. When traders are looking to capitalise on price swings in the stock market, they may employ Gamma to find out certain information that results in profitable trading. Gamma is relevant for any trader.
The domain of trading commonly uses letters of the Greek alphabet to define and describe trading strategies based on certain concepts and processes. Gamma is the Greek letter that is often employed to explain the rate of change within the delta of an option due to a change in the price of the underlying asset in an options contract. Simply put, gamma is a measure of the sensitivity of an option contract’s delta to changes in stock prices. Gamma effectively provides traders and investors with in-depth knowledge of how the delta value of an option may change due to movement in the price of the underlying asset in an options contract. Consequently, traders can indulge in risk management while optimising profits.
Consider a trader named Arjun who wants to monitor changes in an option position. Suppose a ₹1 rise in the underlying stock causes the option’s price to increase by 40 paise. This rate—40 paise per ₹1 change—is referred to as Delta.
Now, over time, as the stock becomes more volatile, this Delta changes. If a similar ₹1 price move now results in a 70 paise increase in the option price, the new Delta is 0.70. The difference between the old and new Delta—here, 0.30—represents Gamma.
In simpler terms, Gamma shows how fast Delta is changing. A real-world analogy might liken Delta to speed and Gamma to acceleration. It reflects the second layer of sensitivity in options pricing, and this helps traders gauge how option values might behave with sharp market moves.
Let’s assume a stock option begins the day with a Delta of 0.25. During the day, the stock price rises by ₹1, and the option value increases by 25 paise. This reflects the initial Delta.
Now, assume after the ₹1 rise, the option’s Delta increases to 0.60. The change in Delta is 0.35. This difference—0.35—is the Gamma.
While this is a simplified example, it demonstrates the concept clearly. In real market conditions, Delta and Gamma fluctuate constantly in response to changes in the stock price and time to expiration. Traders must account for these rapid shifts while managing their options positions.
When discussing Gamma, a few related terms often come into play:
● Delta: The rate of change in the option’s price for a ₹1 change in the underlying asset.
● Alpha: Refers to excess returns earned compared to a benchmark index.
● ITM (In the Money):
-Call Option: When the current market price is higher than the strike price.
-Put Option: When the strike price is higher than the market price.
● OTM (Out of the Money):
-Call Option: When the market price is below the strike price.
-Put Option: When the strike price is below the market price.
● ATM (At the Money): When the market price and strike price are approximately equal.
Understanding these concepts provides a better grasp of Gamma’s behaviour within various option strategies.
Option Gamma trading can be explained through its values and an example. Let’s say, for the purpose of an example, an investor holds a call option having a delta value of 0.50. Now the gamma value of that same option is 0.05. Hence, for every ₹1 rise in the price of the underlying asset, the delta value of the options will go up by 0.05. So, if the stock price increases by ₹1, the investor’s options delta value now, will be, 0.55 (as per 0.50 + 0.05).
Contrastingly, if the stock price declines by ₹1, the options delta value will drop by 0.05, making it 0.45. Such dynamic behaviour of the delta value due to the gamma value is significant for options traders to grasp. It can effectively help them to adjust their trading strategies according to changes in market conditions.
Gamma trading deals with adapting an options portfolio so that it has a neutral gamma position. The advantages of gamma trading are highlighted below:
Gamma trading lets traders systematically manage and lessen their exposure to shifts in price of the underlying asset. If a neutral gamma positon is kept, traders can mitigate any directional risk and avoid losses.
Gamma options trading does well with market volatility. Gamma values are high during such times. Traders gain advantages from swings in price by scalping strategies with gamma values.
Gamma trading is a potential generator of income for traders dealing in options. Gamma scalping may deliver small, but consistent, profits gradually, particularly in markets with extreme volatility.
Gamma trading permits traders to polish their portfolios regularly, fine-tuning their trades to earn profits. Due to typical market sentiment and high market volatility, traders find positions where Gamma aids them in potential profit-making in a diverse range of stocks and securities.
Gamma in trading offers traders a practical and efficient learning experience informing them how options respond to the dynamics of the market. Gamma trading requires regular monitoring, tracking, and active decision-making, aiding traders to enhance their comprehension of the pricing of options as well as risk management.
Additional Read: How Can an Investor Track and Analyze his Equity (Stock) Portfolio?
Whatever options trading you engage in and whichever strategies you apply, the trading does not come without potential risks. In Gamma trading, you require practice and a keen eye on your trading, focusing on conditions of the market, and regular adjustments to your options contracts. Before undertaking such trading, it is important to consider your financial goals and risk profile. You may also wish to consider the costs of transactions involved in options trading.
Additional Read: Options Trading Strategies for Beginners
Gamma plays a crucial role in evaluating how sensitive an option’s Delta is to price movement in the underlying asset. While it provides a more granular view of options pricing dynamics, effective use of Gamma in trading depends on a clear understanding of market behaviour. For traders managing fast-moving or large portfolios, tracking Gamma can assist in making more calculated decisions.
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Gamma is a measure of how Delta changes as the underlying asset’s price changes. Whether it is beneficial or not depends on the specific trading position and market conditions.
Gamma helps track how quickly an option’s Delta changes. It is a useful metric for understanding how responsive an option’s price is to changes in the underlying asset’s price.
This depends on the trading approach. A position with long Gamma reacts differently to price changes compared to one with short Gamma. Each carries its own set of risks and sensitivities.
A Gamma spike refers to a sudden increase in Gamma value, which may occur when options are close to expiry or are trading near the At the Money level.
There is no fixed value that qualifies as “good.” Gamma varies based on factors like time to expiration, strike price, and the volatility of the underlying asset.
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