Understanding the Meaning of Gamma in Options Trading

You already know that an options contract allows the holder to buy/sell the underlying asset at a predetermined price, also called the strike price. Options traders must be familiar with delta, gamma, and other factors. These factors can help understand the pricing of options in the market. Continue reading to understand gamma options in detail.

What is Gamma in Options Trading?

You might be familiar with the fact that gamma is a Greek letter. However, it is also used in the context of options trading . Before delving deeper, it is essential to understand the delta. You must know the role of delta in options trading to understand the concept of gamma. Delta represents the change in the price of the options contract based on every INR/USD 1 change in the underlying asset price. 

The delta for an options contract can range between 0 and 1. Let us say the delta for an options contract based on a commodity is 0.5. It means that when the commodity price rises by Rs. 1, the price of the respective options contract will rise by Rs. 0.5. Gamma represents the change in delta for every 1 rupee/dollar increase in the underlying asset’s value. When the price of the underlying asset increases, the option’s price and delta both increase. 

How to Use Gamma?

Now that you have understood the concept of gamma options let us discuss how to use it. 

• It allows you to measure the change in delta for every 1 rupee increase in the price of the underlying asset. When gamma is high, the volatility of the delta increases. For the same rationale, the option’s price also becomes volatile. 

• You already know that it denotes the rate of change in delta. On the other hand, delta represents the rate of change in the option’s price. Investors rely on it to understand how fast the price of an option will increase when the underlying asset shows an upward movement. 

• Gamma options trading is beneficial for both long and short market positions. Investors can understand the associated price movements and take informed market positions. 

Gamma Calculation

Now that you have understood the options Greeks, it is time to discuss the calculation part. 

Gamma = Change in Delta / Change in the Price of the Underlying Asset 

Experienced traders and brokers often use the black scholes model and other options pricing models to calculate the gamma. Its formula is based on options pricing models and can be a little complex. It includes standard deviation, risk-free rate of return, dividend yield, strike price, and other factors. 

Luckily, options traders can use customized software solutions to calculate gamma within seconds. 

Example

Are you still worried about the gamma risk in options? Let us look at an example. 

• Let’s say the gamma for an option based on a particular stock is 0.5. Also, the delta for the same option is 0.6. The current price of the stock in the market is Rs. 100, and the option’s price or premium is Rs. 10. 

• Let us say the stock’s price increases to Rs. 101. Since the delta is 0.6, the option’s price will be Rs. 10.6 (10 + 0.6). 

• Now, the gamma will increase the delta as the stock price increases. The new delta will be 1.1 (0.6 + 0.5).  

• Let us say the stock price further increases to Rs. 102. Now, the new delta is 1.1. In such a case, the option’s new price or premium will be Rs. 11.7 (10.6 + 1.1). 

Fundamentals of Gamma

Before you indulge in gamma options trading, it is essential to understand its fundamentals: 

• When investors take a long position, they have a positive exposure to gamma. The investor’s portfolio delta becomes more positive as the price of the underlying asset increases. Investors with positive gamma exposure wait for significant price movements to earn high returns. 

• Investors can have a negative exposure when shorting options. Investors with an overall short options position will have a negative exposure. It means the portfolio’s delta will become more negative as the price of the underlying asset increases. 

Beginners in the derivatives trading sector must be familiar with gamma exposure. It can help them with delta hedging, portfolio optimisation, and other processes. You can indulge in risk management by understanding your exposure. 

The formula for Gamma

Gamma represents the change in delta for every 1 rupee increase in the underlying asset’s price in an options contract. However, traders calculate it with the help of several options pricing models. Here’s the detailed formula: 

Gamma Function = e– [d12/2 + d * t] / [(S*σ) * 2πt

In the above formula, 

• d1 = [ln (S/K) + (r+σ2/2) * t] / [σ*t]

• d = dividend yield of the underlying asset 

• t = expiration time of the contract 

• S = spot price of the underlying asset 

• σ = standard deviation of the underlying asset in the contract 

• K = strike price of the asset in the option 

• r = risk-free rate of returns of option 

Benefits of Using Gamma in Trading

Have you ever met an experienced derivatives trader? They will know about delta, gamma, implied volatility, options pricing models, and other terms. It allows them to make informed trading decisions when buying/selling options. Let us discuss how you can benefit by understanding and using options gamma. The biggest advantage is enhanced risk management. You can protect your portfolio from rising prices by managing gamma exposure. Investors can minimise portfolio risks by maintaining a neutral position. 

You already know that gamma is higher for options with high volatility. It means the options pricing will also be more volatile. Scalpers often keep an eye on these price movements to make a profit. However, scalping in options will become difficult when you do not understand these concepts. Gamma scalping might generate small profits when price movements are not significant. However, you can generate these small profits over a long period to build substantial capital. 

Understanding options Greeks can help investors effectively optimise their portfolios. One can adjust their options based on market conditions and potential risks. Many experienced investors rely on them to manage theta (time decay) risks. When potential risks are mitigated, options provide positive or higher returns. 

You can become more informed by understanding the options greeks. You will get to know how options react to market changes. You will be familiar with the changes in premiums based on the price movements of the underlying security. It allows investors to make informed decisions when trading in options. 

In a Nutshell

Options gamma is essential to understand how the premium of contracts changes with price movements in the underlying asset. It represents the rate of change in delta for every 1 rupee change in the underlying asset’s price. New investors must learn the concepts of delta, gamma, and other Greeks before investing in derivatives. Start using options Greeks for trading now!