Options trading: Gamma Explained

Jeff BishopJeff Bishop ·

Options are extremely useful in trading. If you want to learn how to use an options strategy that could potentially more than double your money, check it out here. Now, there’s a lot that goes into options trading, some even say you have to know heavy math like stochastic calculus to trade them…Well, that’s not true. You just need to understand the basics of options and keep it simple. When you’re trading options, the pros know they have to know how “sensitive” they are to changes in different factors. The sensitivities, also known as the Greeks, are extremely useful when you’re trying to break into options trading. The Greeks include delta, gamma, theta, rho and vega (even though vega isn’t a Greek letter). Now, we’re going to be focused on gamma here because it’s an important factor to know when you’re starting out in the world of options trading.

Options trading: Gamma Explained

The pros use gamma to measure how sensitive an option’s price is to changes in delta. Now, an option’s delta measures the changes in an option’s price in relation to changes in the underlying stock’s price. In other words, if a call option has a delta of 0.50, that means for every $1 change in the underlying stock, the option’s delta will change by $0.50. Take note that a put option’s delta is negative. That means if a put option has a delta of -0.50, if the stock gains $1, the option would decrease by 50 cents.

Since the gamma reflects the rate of change of delta, it reflects the fluctuations in delta for a one point move in the underlying stock price.

Keep in mind that gamma is constantly changing even if there are small moves in the underlying stock’s price. Depending on where the stock price is in relation to the option’s strike price, options will have varying gammas. The peak value of an option’s gamma is when the stock price is near the strike price of the option. As you go deeper into or out of the money, the gamma should decrease. Options that are deep in the money or out of the money have gammas close to 0. Moreover, the time to expiration affects an option’s gamma. Gamma tends to be higher for options that are near the money and closer to expiration.

Quick Example

For example, take a look at the options chain for Apple Inc (AAPL). At the time, AAPL was trading at $220.11. Now, if you look at the gamma for the $170 strike price calls, you’ll notice the gamma is 0. Next, look at the gamma for the $267.50 strike price calls. Again, you’ll notice the gamma is 0.

 

options trading

Let’s take a look at how to interpret gamma values.

Gamma Example

When you buy options, you are long gamma. On the other hand, when you short options (which I don’t suggest for beginners) you are short gamma.  Let’s assume a call has a delta of 0.50 and a gamma of 0.02. That means if the stock goes up $1, the delta will increase by the gamma value. In other words, if the stock goes up $1, the delta will increase to 0.52. On the other hand, let’s say the stock goes down by $1, then the delta will drop to 0.48. Keep in mind, when the stock price changes, so will the gamma.

On the other hand, if you buy a put option with a delta of -0.50 and a gamma of 0.02, the opposite is true. If the stock price falls by $1, the delta will decrease by the gamma value. That means the gamma would be at -0.50. On the other hand, if the stock goes up $1, the delta will increase to -0.48.

Remember when I noted time to expiration affects an option’s gamma? Well, as the expiration date approaches, the gamma of at-the-money (ATM) options increases, while the gamma of in-the-money (ITM) and out-of-the-money (OTM) options decreases.

Options trading: Gamma Chart

That said, assume AAPL is trading at $220, and there are 9 days left to expiration. As the expiration date nears, the ATM options will increase. On the other hand, the ATM options with one year until the expiration date may not fluctuate too much.

Now, changes in volatility would also affect gamma values. When the level of implied volatility is low, the gamma of ATM options is high. Conversely, deep ITM or OTM options approach 0. When the level of implied volatility is high, gamma tends to be stable across all strike prices. When implied volatility is high, the time value of ITM and OTM options are high. Therefore, the time value of these type of options as the expiration date nears would have less dramatic moves. Consequently, deep ITM and OTM options have low and stable gamma.

Here’s a look at how gamma looks on this chart.

At the time, AAPL was trading around $220. Notice how the peaks are around the $220 strike price options.

If you want to see how to start trading options, watch this video here.

The Bottom Line

When you’re getting into options trading, one of the key components to understand is gamma. It helps to understand how your position might be affected by changes in the delta of an option. Keep in mind, this is not the be all and end all of understanding options. Now, if you’re ready to really get into options trading – click here.

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Jeff Bishop is lead trader at WeeklyMoneyMultiplier.com and widely recognized as the Mensa Trader. He runs short-term trading strategies, using stocks, options and leveraged ETFs.

 

 

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