Reaping Profits With “Gamma” (Simple Guide)
The big lie on Wall Street is that options trading is too complex for average investors. Not true. With the right guidance, you can unlock the money-making secrets of options. Why let the big boys have all the fun?
Let’s take a look today at Gamma. This seemingly daunting concept has been traditionally left to the experts, but it’s a powerful tool that retail investors can use, too.
If you want to measure how much an option price will change for every $1 change in the underlying security price, look at Delta. If you want to measure how much Delta will change for every $1 change in the underlying security price, look at Gamma.
Gamma is a tricky number because it’s the second derivative of the price and the first derivative of Delta. As a result, many active options traders ignore it.
In this guide, we’ll unpack the complexities of Gamma so you can use it to improve your returns when you trade options.
First Things First: Delta
First, make sure that trading options is right for you.
And before you can understand Gamma, you must first understand Delta.
Delta measures how much the option price changes for every $1 change in the price of the underlying security.
For example, let’s say you’re holding an option worth $2 with a Delta of 0.50. If the underlying security price increases by $1, you can expect that value of your option to increase by $0.50 ($1 x 0.50 = $0.50). Your option would be worth $2.50 in that case.
But once that happens, you can expect the value of Delta to change as well. So what’s the new value of Delta?
To answer that question, you have to look at Gamma.
Gamma: The Basics
Gamma tells you how much Delta will change for every $1 change in the underlying security.
Let’s continue with the example above. Suppose the option’s Gamma is 0.10.
In that case, the new Delta is 0.60. You can calculate that easily by adding the value of Gamma (0.10) to the value of Delta (0.50).
Now, when the price of the underlying security rises by $1, the price will change by $0.60 ($1 x 0.60 = $0.60).
If you’re looking for an analogy, think of Delta as the speed of an option while Gamma is the acceleration.
It’s important to note here that Delta is always a number between 0 and 1.00 (or 0 and -1.00 for put options). Therefore, Gamma is also always a number between 0 and 1.00.
Positives and Negatives
Long options always yield a positive Gamma. Short options always yield a negative Gamma.
What does that mean in practical terms? It means that short options have a negative effect on Delta when the underlying stock price increases.
Let’s say you were short that $2 call option with a Delta of 0.50 and a Gamma of 0.10. If the underlying stock rose by $1, then the value of Delta would drop by 0.10 to 0.40.
Keep in mind: it doesn’t matter if the short position is a call option or a put option. In either case, Gamma is negative.
Where Gamma Peaks
Gamma is generally at its highest for at-the-money options. On the other hand, Gamma is generally at its lowest for options that are deep in-the-money or deep out-of-the-money.
That makes sense if you think about it. Options that are deep in-the-money usually change in price on an almost 1:1 basis (call options) or 1:-1 basis (put options) with the underlying security. You wouldn’t expect that to change much if the stock moves by just $1.
Options that are well out-of-the-money don’t respond very much to changes in the underlying price. They shouldn’t be affected much by a simple $1 move in either direction.
But stocks that are near the money could see significant swings in Delta as the price bounces around. That’s where you can expect to find a Gamma at its highest point.
You can also expect to find Gamma at its peak when the Delta is in the 0.40 – 0.60 range (or -0.40 – -0.60 range).
Gamma is usually at its lowest point when the Delta is close to 1.00 or -1.00.
What About the Expiration Date?
It’s generally true that Gamma is at its highest for at-the-money options as they move closer to expiration.
Once the option crosses the strike price, the Gamma should drop accordingly. Similarly, if the option pulls back from the strike price, the Gamma should decrease.
Implied Volatility and Gamma
Implied volatility (IV) affects Gamma just as it affects other aspects of an option.
As IV decreases, the Gamma of at-the-money call options and put options increases as well. When IV increases, the Gamma of in-the-money and out-of-the-money call options and put options will decrease.
Why? Because options with low implied volatility will see more significant swings in Delta as the underlying price changes.
Options with high implied volatility, on the other hand, will see less significant swings in Delta as the underlying price changes.
Long Option Benefits
As I noted previously, Gamma is positive for long option positions. It’s also positive for your returns if you’re holding a long option position.
If we continue with the example above, let’s say that the $2 call option was a few dollars shy of the strike price. Remember: the Delta is 0.50 and the Gamma is 0.10.
For every dollar the underlying security increases in price, Delta and Gamma will increase as well. Remember: that’s because Gamma increases as the option price gets closer to the strike price.
For the first $1 increase, your call option will increase in value to $2.50 ($2.00 + $0.50 = $2.50). Then, Delta will increase to 0.60 (0.50 + 0.10 = 0.60).
But Gamma will increase as well! Let’s say it bounces up to 0.20.
That means the next time the underlying security goes up by $1, the call option will increase to $3.10 in value ($2.50 + $0.60 = $3.10) while the Delta increases to 0.80 (0.60 + 0.20 = 0.80).
In other words, your option value isn’t just increasing, it’s accelerating. That can work marvelously in your favor if you’ve picked the right stock option.
It gets better. Not only will Gamma accelerate your gains, it will also decelerate your losses.
That’s because Gamma drops as the underlying stock pulls away from its strike price.
In other words, a positive Gamma position can help you limit your losses.
Short Option Risks
Through it all, it’s crucial to pick the right broker when trading options.
Although Gamma can work in your favor when you’re long on options, it can also work against you when you’re short.
Remember: Gamma has a negative effect on short options.
So if you had sold that call option above instead of buying it, Gamma would work against you as the option moved closer to the strike price.
In that case, your losses would accelerate instead of your gains.
That’s why it’s a great idea to pay close attention to Gamma when you’re going short on options.