Understanding options Gamma.
by J Victor on April 21st, 2013We learned about the relevance of Delta in our last post on options. We said that Delta measure of an option will keep on changing every day due to various factors. Since Delta is never constant, an option trader will have to keep a close watch on the rate of change in Delta or the volatility factor of Delta. Gamma is a measure that tracks this rate of change in delta. So if the gamma of an option is .1, it means that the delta of that option changes 10% when there is a Re 1 change in the underlying asset. So gamma is just a continuation of Delta or it can be considered as a derivative of Delta.
We know that the Delta of an option will keep moving towards 1 as the option keeps going inthemoney and conversely, it will move towards 0 as the option keeps moving outofthemoney. Now, the question that needs to be answered is – how fast does Delta change? This vital piece of information, which can be used effectively while taking trading decisions, is measured by Gamma.
For example, you have to opt between two identical options with the same Delta (say, Delta of .6). Since Delta basically measures directional risk, an analysis of its Gamma will reveal which Delta moves fast and which one moves slow. Delta with high Gamma would be the more risky one.
Gamma is a useful tool for traders who take a long or short position in a single option contract. However, the real use of Gamma is in more complex option trading strategies where traders use a combination of long and short positions to make money.
Gamma may be positive or negative. If the Gamma of an option is positive, it means that the change in delta would be positive for a positive change in prices. In other words, the delta of an option will increase as the price of the underlying asset increases. Conversely, if the Gamma of an option is negative, it means that the change in delta would be negative for a positive change in prices. In other words, as the price of the underlying asset increases, the delta will decrease.
If you recall our article on delta, we explained that the delta of inthemoney options will tend to move towards 1 quickly and as the time for expiry draws near, it tends to be less volatile. Logically, as the options moves inthemoney, the Gamma measure will move towards 0 since heavy volatility in delta is quite unlikely. Same is the case of deltas that are deep outofthe money. Deep outofthe money options are unlikely to be less volatile as the option expiry draws near and hence in this case also, gamma will be near to 0. So, as you might have closely observed, Gamma of an option will be at its highest when the option is atthemoney.
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2 Responses to “Understanding options Gamma.”
Mithun
May 17, 2013 at 6:10 pm
Great explaination…waiting for your next post…
Roshan
August 15, 2014 at 5:09 am
I salute you sir. I can’t express my gratitude by words. God bless you sir.