The alpha omega in the infinite universe of options is premium. Every cause and effect that happens when investing in options orbits around its premium and the factors that influence it.
There are other so-called “Greeks” that are within the alpha omega, including delta & gamma, which are metrics that give investors pivotal clues as to how an option’s premium will change. The more investors understand the complexities of option premiums, the more likely they are to be successful. So why not familiarize yourself with powerful tools and metrics that can help you predict how an option’s premium will change?
Gamma is one of those, and is the focal point of this article. We’ll give you an in-depth guide of it here so that you can understand it so it becomes of use to you, instead of being one of the two dozen numbers you gloss over when you’re looking at various option contracts.
What Exactly is Options Gamma?
Gamma is one of what are called “The Greeks”. The Greeks are ‘characters’ in the options world that help investors determine how sensitive an option’s price or premium is, based on various factors such as movements in the underlying price and time decay.
Gamma is essentially delta’s partner, as they’re both tied together with an option premium’s sensitivity to movements in the underlying price. Delta measures the theoretical move in the option’s premium based on changes in the underlying price, and gamma measures how an option’s delta will change based on changes in the underlying price.
Imagine a stock has a delta of 0.50; that means the option’s premium will increase (theoretically) $0.50 if the underlying price goes up $1.00. To find gamma you’d take the difference of the delta before and after the move, and divide that by the difference in the underlying price. That might be confusing, but don’t worry, it’s pretty straightforward, and we’ll break it down in the next section.
How is Gamma Calculated?
The “actual” calculation of gamma is rather complicated, but we’ll give you the basic way that most investors use to understand its calculation. Simply take the difference between deltas and divide that by the difference in the underlying price. This can be done by recording those values at the beginning and end of a day, for example.
(D1 – D2)/ (U1 – U2) = Gamma
So, for example:
(50 – 42) / ($100 – $85) =
(8 / $15) = 0.53 is the gamma value. So, theoretically, for every $1.00 move in the underlying, the delta value will move 0.53.
*Note that the delta values are expressed in terms of the whole contract instead of per share. Where normally you’d have a delta of 0.50, per share, and there are 100 shares, which makes the overall delta of the first contract 50.
So you would find the difference between the delta at the beginning of the day (D1) and the end of the day (D2), and divide that value by the difference between the underlying price at the beginning of the day (U1) and the end of the day (U2). The quotient of that is your gamma value, or the theoretical value delta will move based on a $1.00 move in the underlying.
Understanding the Uses of Options Gamma
The Greeks are different metrics used by investors to assess risk, specifically the different factors that affect the premium of an option, and how much it would affect it, in theory. Delta is sort of paired with gamma, as they both have to do with the effects of an underlying price movement versus a movement in time.
We mention delta because, although it is very useful for investors to understand how options’ premiums are affected, delta changes a lot, and can prove difficult to track and use by itself to make decisions. This is where gamma comes in, lending you some more foresight to the future in the world of trading options.
Consistently successful investors don’t just use a couple of indicators/ metrics to base their decisions on, they aggregate as many tools as they can into one investment decision to set themselves up for success. Using delta and gamma in tandem helps get you on the right track. A step up could be to incorporate trading alerts – live updates on trades coming in and out that you can follow with your account.
Quick Example of Gamma in Options
Alright, say you’ve been trading long shares of Apple, Inc. (AAPL) and are interested in trading some of its options but are curious about how the underlying price will affect the premium, specifically gamma. Oftentimes a brokerage will just list the value and there is no need for a manual calculation. But, understanding how to calculate gives you some insights into the interconnectedness of factors that will directly premiums.
So say we’ve read/ recorded, or calculated, that gamma is 0.025. This means that if AAPL’s price falls by $1.00, the delta will fall by 0.025. This tells us that the underlying price will be slightly less sensitive to underlying price movements.
Here’s what gamma and the other Greeks look like on Robinhood:
The image above shows a clear view of the variables related to an AAPL call. At the bottom you’ll see the five Greeks, including gamma.
If the underlying price continues to fall, going deeper out of the money, gamma will fall with it, moving closer to zero. This is the same case if the price were to move deeper into the money, gamma will also move closer to zero. It’s only when the option gets closer to the money (closer to the at-the-money value) that gamma is the highest.
Gamma Hedging: How Does it Work?
Gamma hedging seeks to create the most neutral (closest to zero) overall gamma possible. What this means is, if you have an option position open with a gamma of 0.058, for example, to ‘gamma-hedge’ the position, you would sell an option that has a gamma as close to 0.058 as possible.
What is the point of doing that, though? The more gamma-neutral your position is, the less it will be affected by movements in the underlying price. It’s like giving your position a big, warm jacket to wear in case the weather gets bad. This is the basic concept of hedging – protecting your position from exposures to risk such as underlying price movements.
Now, if you’re looking to employ more sophisticated options strategies, you can take gamma hedging a step further and pair it with delta to create a delta-gamma hedged position. Delta-neutral strategies work in the same way as gamma-neutral strategies: you seek to create a neutral delta via buying and or selling other options to balance, or bring the delta as close to zero as possible so that the overall position is protected from underlying movement.
Why Do Gamma Squeezes Happen?
Gamma squeezes happen as a result of a sudden, short-term, skyrocket in the underlying price. Perhaps the best example of this is something most of us are probably familiar with: Gamestop (GME). Exploding like a supernova, GME went up more than 680% in 2021, putting Reddit and a new generation of traders in the minds of corporations and seasoned vets. But let’s get back to gamma squeeze.
All that’s happening with gamma squeeze is, when an underlying price shoots up, an option’s premium moves abruptly. The change in premium can move in either direction depending on the specific circumstance.
There are opportunities to profit during gamma squeezes, but tread lightly. The whole essence of why gamma squeezes happen is because of huge short-term price movements, so another (possible opposite) huge price move isn’t unlikely to happen soon after.
Gamma is a useful tool for options traders to better understand the interconnectedness of underlying price movements and option premiums. Delta plays a crucial role in that mix, and without understanding delta, gamma is useless to investors.
Gamma is the theoretical move in delta based on a $1.00 move in the underlying. So if an option has a 0.20 gamma, if the underlying price moves down $1.00, the delta will fall by 0.20.
As investors, we’re trying to establish as clear a picture as possible of the market and the specific securities we are potentially interested in investing in. Therefore it’s advantageous to every investor to incorporate as many factors into their decision and perspective of the market as possible, and gamma is a powerful metric to throw into that mix.
Gamma Squeeze in Options Trading: FAQs
What is a Good Gamma Range for Options?
A good gamma entirely depends on the specific investor and their goals. Perhaps they are less averse to risk so they want to be more conservative, perhaps seeking to create a gamma-neutral portfolio. While others might be more aggressive and jump into positions with a high gamma, seeking to make large gains in a short time.
If you’re new to gamma and how it works, perhaps the range is plus or minus 0.5. This is the ‘mid-range’, where a contract’s delta won’t be drastically changed, or hardly changed, but right in the middle so that you can get a good idea of how it works.
How is Gamma Used in Options Trading?
Gamma is used in options trading by investors that want to have a better idea of how an option’s premium will be affected by movements in the underlying price. Where theta and vega relate to movements in time, delta and gamma relate to movement in the underlying price.
Delta, specifically, measures how the premium will move, and gamma measures how the delta will move. So it gives investors a more complete view of the factors at play influencing premium.
Is Gamma Always Positive?
No, gamma is not always positive. It is, however, always positive for long positions, while gamma is negative for short positions.
Is High or Low Gamma Good Options?
A high gamma could be more advantageous for those that want to take advantage of increased risk, while a low gamma might be better suited for those that aren’t comfortable taking on as much risk, or as little risk as possible.
The reason higher gammas are riskier is that they have a greater theoretical impact on the delta, thus having a greater potential impact on the premium. Lower gammas could be good for those that don’t want to take on as much risk, and also minimize the number of factors at play affecting premium.
What is Gamma Risk in Options?
Gamma is a risk metric, and the higher gamma is, the riskier the investment is, and visa versa. So gamma risk is the risk associated with its value.