What Does Gamma Mean in Options Trading?

Options contracts provide investors with the opportunity to speculate on an underlying asset’s future price without owning it. Traders use “Option Greeks” to manage the complexities and risks. These metrics quantify an option’s sensitivity to factors like price changes, time decay, and volatility. Gamma is a particularly important measure, showing how an option’s price sensitivity changes as the market moves.

Defining Gamma

Gamma represents the rate at which an option’s delta changes in response to a $1 movement in the underlying asset’s price. Delta measures an option’s price sensitivity to changes in the underlying asset’s price, indicating how much an option’s value changes for every $1 move in the underlying. For example, a delta of 0.50 means the option’s price will move by $0.50 for every $1 change in the underlying asset.

Gamma measures the acceleration of that delta. A higher gamma means an option’s delta changes significantly with small movements in the underlying asset. For instance, if an option has a delta of 0.40 and a gamma of 0.05, a $1 increase in the underlying asset’s price would cause the delta to increase to 0.45. This dynamic nature of delta, influenced by gamma, is an important aspect of options pricing.

Options positions can have either positive or negative gamma. Long options, whether calls or puts, have positive gamma. This means their delta increases as the underlying asset’s price moves favorably and decreases as it moves unfavorably. Short options carry negative gamma, meaning their delta moves opposite to the underlying asset’s price movement.

Variables Affecting Gamma

An option’s gamma value is not static; several factors influence how sensitive delta is to price movements in the underlying asset.

Time to Expiration

Time to expiration is a key factor for gamma. Gamma values are highest for options nearing their expiration date, especially at-the-money options. As an option approaches expiration, its delta can shift rapidly between near zero and near one (or negative one for puts). This happens because the probability of an option finishing in-the-money changes dramatically with small price movements when little time remains. Options with more time until expiration have lower gamma.

Moneyness

Moneyness, an option’s strike price relative to the underlying asset’s current price, also impacts gamma. Gamma is highest for at-the-money (ATM) options. These options have the highest gamma because their delta is most sensitive to changes in the underlying price, being on the cusp of in-the-money or out-of-the-money. As options move further in-the-money (ITM) or out-of-the-money (OTM), their gamma decreases. This is because deep ITM options have a delta near 1 (or -1), and deep OTM options have a delta near 0, so their deltas do not change as quickly with further price movements.

Implied Volatility

Implied volatility also affects gamma. Higher implied volatility leads to lower gamma, and lower implied volatility results in higher gamma. This inverse relationship exists because high implied volatility means the market expects a wider range of potential price movements. This wider range flattens the delta curve, making delta less sensitive to small price changes and reducing gamma. Conversely, low implied volatility suggests a narrower expected price range, making delta more responsive to price changes and increasing gamma.

Gamma’s Importance for Traders

For options traders, understanding gamma is important for risk management and strategy. It provides insight beyond delta, showing how a position’s directional sensitivity changes as the underlying asset moves.

Delta Hedging

Gamma influences delta hedging, which aims to create a position neutral to small price movements. Options with high gamma require more frequent adjustments to maintain a delta-neutral position. This is because high gamma means delta changes rapidly with underlying price movements, requiring more frequent buying or selling of the underlying asset or other options to rebalance the hedge. Conversely, positions with lower gamma require less frequent adjustments, as their delta is more stable.

Profit and Loss (P&L) Profile

Gamma also affects a trader’s profit and loss (P&L) profile. A long gamma position benefits from large price movements in the underlying asset, regardless of direction. As the underlying moves favorably, the option’s delta increases, accelerating profits. If the underlying moves unfavorably, the delta decreases, decelerating losses for a long option position. In contrast, a short gamma position benefits when the underlying asset remains stable or experiences small movements, but it faces increasing losses with large price swings.

Gamma and Theta

There is an inverse relationship between gamma and theta, another Option Greek measuring an option’s value decay over time. Options with high gamma also experience high theta decay, especially as expiration approaches. While a long gamma position can benefit from significant price movements, it incurs a higher cost due to time erosion. Traders often face a trade-off: pursuing high gamma for potential large gains comes at the expense of accelerated time decay.