Gamma

Definition

Gamma is a measure of the rate of change of an option's delta with respect to changes in the underlying asset's price. It reflects the sensitivity of an option's delta to movements in the price of the underlying asset, helping traders assess how much the option's price might change as the underlying asset fluctuates. Understanding gamma is crucial for managing risk and making informed trading decisions in financial derivatives and options pricing.

5 Must Know Facts For Your Next Test

1. Gamma is highest for at-the-money options and decreases for in-the-money and out-of-the-money options.
2. A high gamma indicates that delta can change rapidly, which can lead to increased risk and volatility for traders.
3. Gamma is a second-order derivative of the option price, making it a key factor in assessing an option's sensitivity to price changes.
4. Traders often use gamma along with delta to manage portfolios and hedge against significant price movements in the underlying asset.
5. Understanding gamma can help traders anticipate how their positions may behave as market conditions shift, particularly during periods of high volatility.

Review Questions

• How does gamma impact the risk profile of an options trading strategy?
  • Gamma significantly impacts the risk profile of an options trading strategy by indicating how sensitive an option's delta is to changes in the underlying asset's price. A high gamma means that delta can change quickly, which can increase potential gains but also heighten risk if prices move unexpectedly. Traders must monitor gamma closely to adjust their hedging strategies and manage their exposure effectively, especially when market volatility is high.
• Compare and contrast gamma with delta, focusing on their roles in options pricing.
  • Gamma and delta are both crucial metrics in options pricing, but they serve different purposes. Delta measures how much an option's price changes with a $1 change in the underlying asset, while gamma measures how much delta itself changes as the underlying price fluctuates. While delta provides immediate insight into directional risk, gamma offers a deeper understanding of how that risk can evolve with larger movements in the underlying asset's price, allowing traders to better anticipate potential changes in their positions.
• Evaluate the importance of gamma when managing a portfolio of options in volatile market conditions.
  • In volatile market conditions, gamma becomes critically important for managing a portfolio of options because it provides insight into how quickly delta can change as prices fluctuate. A high gamma indicates that options may experience rapid changes in their delta, increasing both potential rewards and risks. By evaluating gamma alongside other Greeks like delta and vega, traders can make more informed decisions about hedging strategies and position adjustments, ultimately enhancing their ability to navigate turbulent markets effectively.

Related terms

Delta:

Delta measures the rate of change of an option's price relative to changes in the price of the underlying asset, indicating how much the option price will move for a $1 change in the underlying.

Vega: Vega measures an option's sensitivity to changes in the volatility of the underlying asset, indicating how much the option price will change as market volatility increases or decreases.

Theta:

Theta measures the rate at which an option's price decreases as it approaches its expiration date, quantifying time decay and its impact on option pricing.