Gamma is the rate that the delta of an option changes. This change is in comparison to changes in the underlying’s price. Gamma measures the increase or decrease in the amount delta changes for a single point change in the underlying asset’s price. A higher gamma responds more to the underlying price changes; a lower gamma is less responsive. Delta has different rates of change, and therefore different gammas, based on the underlying market price’s relation to the strike price. Gamma’s formula makes detecting these changes easy:
Gamma also lets you estimate what gains or losses will be incurred based on the underlying price movement. Gamma is positive if the position is a long purchase, and negative if the position gamma is a short sale. Calls are positive, and puts are negative. Note: it doesn’t matter if delta moves up or down, gamma is still displayed positive if long and negative if short.
Degrees of Movement
Gamma’s movement is strongest when an option is at the money and close to the expiration date. Underlying price changes matter the most for at the money options, and gamma has its highest impact at this level. Gamma is smallest when an option is either deep in the money, or deep out the money. Gamma increases as prices move closer to at the money status, and decreases as gamma moves in the money or out the money.
Gamma and Expiration
Gamma is affected by the length of time until expiration. An option which is near the expiration date will have a higher gamma than an equal option farther from its expiration date. Underlying asset price changes will have a higher impact if there are only a few days left in an option’s trading window, versus a few months.
Gamma and Trading
Gamma affects your trading decisions. A higher Gamma will provide the most profit quickly, but you will also suffer the most loss if the market moves against you. A lower Gamma will be slower to provide profit or loss. This indicates that a short term strategy works best with a higher Gamma, due to less time to actually earn profit, but only if you’re absolutely correct. A longer term strategy will work better with a lower gamma, which will have more time to move into profitability. If it moves opposite to your desires, you can neutralize the position before you incur substantial losses.
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