Gamma: Don’t Ignore This Forgotten Greek

05/22/2012 7:00 am EST

Focus: OPTIONS

Dan Passarelli

Founder, Market Taker Mentoring, LLC

Gamma is a secondary option “Greek” that measures the rate of change in an option’s Delta relative to a change in the underlying, writes Dan Passarelli, explaining how traders can use this measure to their benefit.

The trifecta of option “Greeks” are Delta, Theta, and Vega, but the next most important Greek is Gamma. Options Gamma is a one of the so-called second-order option Greeks. It is, if you will, a derivative of a derivative. Specifically, it is the rate of change of an option’s Delta relative to a change in the underlying security.

See related: Know Your Option Greeks

Using options Gamma can quickly become very mathematical and tedious for novice option traders, so for newbies to option trading, here’s what you need to learn to trade using Gamma.

When you buy options, you get positive Gamma. That means your Deltas always change in your favor. You get longer Deltas as the market rises; and you get short Deltas as the market falls.

For a simple trade like an Apple, Inc. (AAPL) June 540 long call that has a Delta of 0.48 and Gamma of 0.008, a trader makes money at an increasing rate as the stock rises and loses money at a decreasing rate as the stock falls. Positive Gamma is a good thing.

When you sell options, you get negative Gamma. That means your Deltas always change to your detriment. You get shorter Deltas as the market rises and longer Deltas as the market falls.

Here again, for a simple trade like a short call, that means you lose money at an increasing rate as the stock rises and make money at a decreasing rate as the stock falls. Negative Gamma is a bad thing.

Start by understanding options Gamma from this simplistic perspective, and then later, worry about working in the math.

We all know options are derivatives, and their prices are derived from the underlying stock, index, or ETF. But with other factors at work—implied volatility, time decay, etc.—how can you know how much an option is going to move with respect to said underlying? Very simple...check out its Delta.

Delta is arguably the most heavily watched Greek, especially by individuals new to options. It offers a quick and dirty way of telling us what to expect from our option positions as we watch the price action of the underlying. Calls have positive Deltas, as they typically move higher on a rise in the stock, and puts have negative Deltas, as they typically move lower when the stock rises.

While some traders view Delta as the percentage chance an option has of expiring in the money, it is really more of a way to project expected appreciation or depreciation. A Delta of 50 for an AAPL call suggests the option should move 50 cents higher when AAPL jumps a dollar, and lose 50 cents for every dollar loss in AAPL.

But Delta is only foolproof when all other factors hold static, which is rarely the case (and certainly never the case for time decay). If an option is moving more (or less) than its Delta would suggest, it is likely because other variables are shifting. 

For example, buying demand might be pushing implied volatility higher, raising the price of the options. Still, this king of all Greeks is a good starting point for gauging how your options are likely to move.

See also: Delta: King of All Option Greeks

By Dan Passarelli of MarketTaker.com

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