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Introduction to Gamma - Options Mastery Series Lesson 11

Filed Under Options Mastery Series 

Most option traders are very familiar with “the big Greek” Delta, which represents the change in the options price with the corresponding movement in the underlying stock. Delta is given as a percentage because the option moves at a certain percentage rate against the stock. As a stock trades up higher an in-the-money option moves further in-the-money, its Delta is also increasing. The famous Delta smile demonstrates how Delta increases on either side of at-the-money. There’s no doubt about the importance of Delta but it’s sister Greek, Gamma, also plays an important part in gaining a full understanding of stock options.
 
Gamma is the second derivative of Gamma and measures the rate of change of Delta. Gamma is going to tell us- before the fact - how much Delta is going to change with a movement in the underlying stock; therefore, Gamma measures the rate of the change of the rate of change.
 
Any time you buy any type of option, whether it be purchasing a put or purchasing a call, it doesn’t matter which one, you are going to acquire long Gamma. When an option trader sells an option they acquire short Gamma.
 
Stock options were originally developed to help hedge risk. It was found that by purchasing a certain amount of puts or selling a certain amount of calls can offset potential portfolio losses of unrealized gains. Hedging is still a very important aspect of stock options and understanding Gamma is key to understanding hedging. But we get ahead of ourselves.
 

When we’re talking about hedging and understanding what’s happening to our position, option traders need to know what is happening to options ahead of time, not after the fact. This is where Gamma comes in. This advance knowledge allows us to hedge properly because we can see before hand how many Deltas we will need to offset the stock.

In its Options Mastery Course, Options University presents the following example. Suppose you are long 1,000 shares. With the stock at $55 your long 1,000 shares equals long 1,000 Deltas. You Hedge with long 20 May 55 puts, which gives you a minus or short 50 Deltas (the-at-the-money puts have a Delta of 50). 50 short Deltas per put contract times 20 is short 1,000 Deltas. Therefore we are delta neutral which is what we need to properly hedge the stock position. But as option owner, you also own some Gamma and in this example we have total Gamma of 250. If you are long 250 Gamma and the stock trades up one dollar from $55 to $56, at $56 we should have a new Delta position of long 250. As the stock trades up, these puts lose their Delta, as they were at-the-money, they’re now becoming out-of-the-money as the stock moves up. They’re having less negative Deltas so at $56 your 20 long 55 strike puts are no longer providing us short 50 Deltas. They’re now providing you with short -750 Deltas. At $56, we’ve got 1,000 Deltas long from the stock but short 750, thus we become long 250 Deltas for every dollar that the stock moves up.
When we’re long Gamma and the stock trades down, you’re going to acquire short Deltas. So that means if the price of the stock goes down to $54, you will be short 250 Gammas. To keep delta neutral, you will know ahead of time how many options you must buy or sell to get back to Delta neutral for balanced hedging. This same scenario of Gamma providing a future idea of where Delta will be can also be used in a trading strategy just trading gamma, but that story is for another day.
 
For more information on all aspects of stock options, contact Options University at www.optionsuniversity.com.   

In its Options

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