Gamma is another key variable in the option Greek you need to know how you can use it to know the sensitivity of the option premium price. The other key members are Delta, Vega and Theta, which are interrelated with each other and can be used to determine the option price.
And the main motive of utilizing these option Greeks is to know the sensitivity of option premium against the change in the price of the underlying security. Here in this article, you will get to know about Gamma how it works and how you can use it for options trading.
What is Gamma in Options Trading?
Gamma is simply a tool or you can say measurement instrument to know how much Delta is sensitive towards the change in the price of the underlying security. This means Gamma shows how much point Delta is changed on every one point change in the price of the underlying security. You can say the Gamma is the Delta of Delta or sensitivity is how much sensitive.
The higher the value of Gamma, the higher the Delta is highly sensitive which makes the option price more sensitive towards any change in the underlying security. If the Gamma is low, it means the Delta changes slowly, making the option price less volatile.
How Gamma Works in Options?
As we know, Gamma tells the intensity of change in the Delta when there is one unit change in the price of the underlying security. The value of Gamma always remains positive for both call and put options but if the option contract is at the money, Gamma will be higher that goes becomes lower when the option is in the money or out of the money.
To understand how Gamma works in options, let’s take an example. Suppose the Delta value of an option is 0.6, and if the price of an underlying security moves by 1 point, then the price of the option of the same underlying security moves by 0.60. The steep movement in option price brings the spot price closer to the strike price which makes Delta 0.75.
Here 0.15 is the Gamma that makes option moves by 0.75, when the price of the underlying security moves by 0.60. However, the Delta always remains variable and cannot be more than 1.0, but the Gamma value can drop when the option further gets closer to the Money and the Delta becomes 1.00. A high Gamma value means the option is highly volatileand a Gamma with a low value means the Delta will change slowly because of low volatility.
How to Use Gamma in Options Trading?
Just like other option Greeks, you can also use the Gamma in option trading to define your trading strategy and trade with the right strategy. Here you need to understand how you can use the Gamma in options trading, as it can tell you the sensitivity of Delta towards the price change in the underlying security. As per the Gamma value of the underlying security, you can trade with long, short or Gamma hedging strategies, let’s discuss these strategies in detail.
Long Gamma Trading Strategy
Long Gamma means Gamma with positive value indicates the Delta of long option contracts, either its call or put will increase when the price of the underlying security rises and falls when stock falls. Long gamma position will notice ever increasing delta when the underlying.
Here you can sell Delta as the price increases and then buy the Delta as prices go down, entering into long Delta can give you profits if you keep following the buy low and sell high trading strategy.
However, while trading in a Gamma long position if you buy a call or a put, your option trade position will have a positive gamma exposure. This positive Gamma means the value of positive Gamma is added to your Delta when the price of the underlying security increases, and deducted from the Delta of your position when the price of the underlying security decreases.
Here in the long call position Delta becomes more positive, let’s say moves towards +1.0, while long put position Delta becomes less negative, let’s say moves towards 0, then the share price moves up. However, a Delta in a long call position becomes less positive and becomes 0, and a Delta in a long put position becomes more negative moving towards -1.0, when the price of the underlying security falls.
Short Gamma Trading Strategy
Short Gamma or you can say negative Gamma indicates the Delta of short calls, it is called or put, it will become less positive or more negative when the price of the underlying security rises, and more positive or less negative when the price of the underlying security falls.
Here in the short option, Gamma is deducted from the option Delta, when the price of the underlying security increases. And gamma is added to the option Delta, when the price of the underlying security decreases this will have the reverse impact on the Delta as compared to long positions.
In the short gamma trading strategy, the Delta of an option trade position with a short call becomes more negative, or you can say inches towards -1.0, and the Delta of the short put position becomes less positive or moves towards 0, because the price of the underlying security decreases.
On the other hand, a delta of a short call position becomes less negative or moves towards 0. However, the Delta of the short put position becomes more positive moving towards +1.0, as the price of the underlying security declines.
However, while trading in the short gamma strategy, keep in mind the higher Gamma can increase the risk for the option sellers as the option moves with the faster movement. This is because a higher Gamma shows faster movement of the underlying and options can face unexpected swings in profit and loss.
While the short uncovered option has more risk, the high Gamma increases this risk as the price of the underlying security moves in either direction pushing the trade position into the loss at a faster speed than your expectations.
