Gamma

Definition

Gamma is a second-order Greek that measures the rate of change in an option's delta in relation to changes in the price of the underlying asset. It provides insights into the convexity of an option's price curve, helping traders understand how sensitive the delta is to movements in the underlying asset. Understanding gamma is crucial for managing risks and making informed decisions about hedging strategies.

5 Must Know Facts For Your Next Test

1. Gamma is highest for at-the-money options and decreases for deep in-the-money or deep out-of-the-money options.
2. A high gamma indicates that delta can change rapidly with small movements in the underlying asset, making it crucial for traders to monitor their positions closely.
3. Gamma can also provide insights into how much hedging needs to be adjusted as the price of the underlying moves.
4. Traders often look for options with favorable gamma characteristics when implementing delta-neutral trading strategies.
5. Gamma hedging involves taking positions that counteract the changes in delta, allowing traders to maintain a more stable risk profile.

Review Questions

• How does gamma impact the management of an options trading portfolio?
  • Gamma plays a vital role in managing an options trading portfolio by indicating how delta, which measures price sensitivity, may change with fluctuations in the underlying asset. A trader must keep a close eye on gamma to adjust their hedges appropriately, especially when dealing with at-the-money options where gamma is highest. Ignoring gamma can lead to unanticipated changes in risk exposure, making effective portfolio management challenging.
• Discuss how gamma relates to hedging strategies and why it is important for traders.
  • Gamma is crucial for hedging strategies because it informs traders about how quickly their delta hedge might become ineffective due to changes in the underlying asset's price. By understanding gamma, traders can adjust their hedge ratios more effectively and anticipate adjustments needed as market conditions fluctuate. This knowledge allows for better risk management and enhances the overall effectiveness of their trading strategy.
• Evaluate the implications of gamma when considering option pricing models like Black-Scholes and binomial models.
  • In both Black-Scholes and binomial models, gamma provides important insights into option pricing dynamics as it reflects how delta changes with varying underlying prices. Understanding gamma helps traders identify potential price volatility and manage their portfolios more effectively by anticipating changes in delta due to shifts in market conditions. Analyzing gamma alongside other Greeks within these models enables traders to formulate more comprehensive strategies and make well-informed decisions based on expected movements in both options and their underlying assets.

Related terms

Delta: Delta is a first-order Greek that indicates how much an option's price will change for a $1 change in the underlying asset's price.

Vega: Vega measures an option's sensitivity to changes in volatility, indicating how much the option price will change with a 1% change in implied volatility.

Theta: Theta represents the rate at which an option's price decreases as it approaches expiration, reflecting the time decay of the option.