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.
Also Read: How to Trade in High Volatile Market: Best Trading Strategies
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.
Also Read: How to Recover Loss in Option Trading: Tips to Avoid Losses
Gamma Hedging Option Trading Strategy
Apart from long gamma and short gamma trading strategies, you can opt for the gamma hedging option trading strategy. This gamma option trading strategy tries to maintain a balance between positive and negative Delta to neutralize the impact of both types of delta values.
To trade with this strategy, you have to buy and sell options in such a way as to offset both types of Delta making the net gamma to nearest around zero. This kind of option trade position is known as gamma neutral and traders try to maintain zero gamma with the delta neutral position.
Trading with delta-gamma hedging, both net delta and net gamma become close to zero. In such cases, the option position is hedged against the fluctuation of the price of the underlying security reducing some degree of the directional risk that can come due to unexpected volatility.
The price of the underlying securities categorized in the option trading keeps fluctuating on a daily basis, hence the hedging positions also need to be adjusted. And when you maintain the delta hedging either daily weekly or monthly it is called the gamma hedging.
However, the gamma strategy is not executed individually, instead, it should be used in combination with a volatility-based trading approachthat utilizes delta-neutral hedging.
Also Read: What Option Strategy is Best for High Volatility: 6 Strategies
How to Implement Gamma Hedging Strategy?
To implement the Gamma hedging strategy you should have a deep understanding of various factors affecting the price of the option premium. Apart from that also understand the behaviour of other variables in the option Greeks, market sentiment expiration dates of options contracts etc. Let’s find out how to implement the gamma hedging strategy. Identify the Underlying Security
To implement a successful gamma hedging strategy you need to identify the right underlying security. Yes, pick the right underlying security from the derivatives segment that has significant trade volume in options aligns with the market sentiment and fits into your trading strategy. You also need to check the level of liquidity in the various strike prices of the underlying security to ensure you can quickly adjust your trade positions as per the market change.
Identify the Precise Timing of Hedging
Timing is another important factor you need to identify precisely in Gamma hedging. The timing in gamma hedging involves identifying the adjustments when required as per the market change to minimize the impact of risk within the scope of the trading strategy.
Moreover, you also need to monitor the market situation, level of Delta and exposure of Gamma to make the decisions at the right time.
Adjust Your Portfolio for Gamma Hedging
In gamma hedging, you, need to constantly monitor and adjust the trade position. To rebalance the portfolio you need to buy and sell options to maintain the neutral gamma position. This dynamic behaviour of gamma ensures you are ready to sail across as per the changing market situations.
Moreover, you also need to trade with the most advanced option strategies like strangles or straddles that will boost your gamma hedging approach by offering an additional layer of flexibility as per the volatility in the market. This strategy will allow you to earn profits with significant movement while you maintain the level of gamma exposure in your trade position.
Also Read: What are the 4 Levels of Advanced Options Strategies to Trade
Choosing the Right Amount to Hedge
To implement the right gamma hedging strategy you also need to determine how much portion of your trade or portfolio needs to be hedged. You have to calculate the precise level of gamma exposure while considering the sensitivity of the portfolio delta and your risk tolerance. To enter into such a calculative trading strategy, you need to go through a set of complex financial models and also should have a thorough understanding of the options pricing and its dynamics.
Gamma Blast Trading Strategy
Gamma blast in options trading is the rapid increase in the value of low-pricing traded options because of the sudden movements in the Gamma of the underlying security. To trade with the Gamma Blast strategy you need to understand the market conditions and, the right timing to enter the trade and use the straddle charts to find out the breakout points for options trading.
To implement the Gamma blast trading strategy on expiry day you have to enter a put option trade based on the breakout analysis that you can utilize through straddle charts. But backtesting and risk management are one of crucial points to evaluate the effectiveness and loss potential of the strategy, as sometimes this strategy doesn't work.
Also Read: How to Manage or Do Risk Management in Options Trading
Conclusion
Gamma simply tells you how much Delta is sensitive towards the movement in the price of the underlying security. Gamma always remains positive for both call and put options and the value for gamma remains between the ranges of 0 to +1. You can utilize the Gamma in options trading with long, short Gamma trading and neutral hedging Gamma strategy.
The long gamma strategy is the Delta of long options that will become positive when the stock price moves up and less positive when the underlying security price falls whether it is call or put. While short option strategy shows the Delta of short calls that become less positive when the underlying security rises, and more positive when the price of the underlying security decreases.
However, in the Gamma hedging strategy, you have to trade with Delta neutral to maintain the balance between the positive and negative delta. And to trade with delta neutral strategy you have to buy and sell the options in such a way that gamma becomes close to zero. This will help you to minimize the risk of the impact of the volatility on the option price. And you would be able to trade with the most optimized option strategy for the best results.
