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Good and Bad Gamma - Options Mastery Series Lesson 14

Filed Under Options Mastery Series 

One of the barriers that keep many stock traders from becoming successful option traders is understanding the importance of the Greeks. These are important variables spun out as part of the calculations of the Option Pricing Model. One of them causes particular confusion because it is a second derivative of its important litter mate-Delta. Gamma, the second derivative of Delta, discloses what will happen to Delta if the underlying stock moves $1. For instance, if the Gamma of a certain strike price is 10 and Delta is 55, that means if the underlying stock moves up $1, the option’s Delta will move 10 points to 65. But this rather simple relationship becomes more complicated as one delves deeper into Gamma. For example, there is an anecdotal classification of Gamma into bad Gamma and good Gamma.
 
Long calls and long puts both always have positive gamma. Short calls and short puts both always have negative Gamma. When we talk of short Gamma (negative gamma), that appears to be the reason some call it “bad Gamma”. Some important characteristics of short Gamma are:
 
With a short Gamma position, as the stock trades down, we need to get longer. That means we’ve got to sell, which is equivalent to selling low.
 
Conversely, if the stock goes up when we are short Gamma, we’re getting shorter forcing us to buy more stock to stay flat. This means we are buying high.
 
The above sell-low and buy-high situation is the formula for losing money and has prompted the naming of short Gamma as Bad Gamma.
 
On the other hand, long Gamma is “good Gamma” because you get to buy low and sell high. This can be confusing so to reiterate, when hedging and with long Delta, if the underlying price goes up, we’re going to get longer Delta to stay Delta neutral. If the price goes down, we’re going to get shorter Delta. On the other hand, when short Delta, as the stock trades up we’re going to acquire shorter Delta. As the stock trades down, we’re going to get longer Delta (close out positions). Because of the buy-high sell-low conundrum, most traders stay away from taking up a short Gamma positions. But hold on. If only it were that simple. You see, another Greek, Theta also plays an important part as we get closer to expiration, the time decay of Theta also comes into play by affecting Gamma.
 
When using stock options to hedge a long stock position, it is important to understand how you’re total position is going to change as the stock moves. Gamma is going to tell you that ahead of time from the standpoint of what Delta will become when the underlying stock moves up or down.
 
But that’s not all that Gamma is good for. As a matter of fact, trading Gamma is a specialized trading strategy for making short term swing trades. But that‘s a subject for another day.
 

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