Option Trading Lesson: What the Heck is Gamma?

Posted by jbrumley on April 1, 2021 9:00 PM

Whether you're an option trading veteran or a newcomer, you've likely come across the term "gamma." And, whether you're an option trading veteran or newcomer, you've likely looked right past it to focus on the more approachable and less esoteric matters to trading. And that's ok. Plenty of traders find good success without mastering these less-used "Greek."

On the other hand, it never hurts to know what it is and how it works. Knowledge gives you an edge on your trading competition, and just might translate into bigger and better results.

First things first. What's gamma? The simplest way to describe it as the rate of change for an option's delta based on a one-point change in the price of the underlying stock or index. In some regards it can be considered the delta of an option's delta, presuming you already understand that delta is a reflection of how much an option's price changes as the price of its underlying stock moves.

Generally speaking you want a higher delta because it means that option is more responsive to changes in a stock's price. But, in that delta itself changes as the value of the underlying stock does, that responsiveness can change too. Gamma shows you how much or how little delta is likely to change. The higher the gamma, the more delta changes when a stock's price moves. The lower the gamma, the less change you'll see in the delta as a stock's price rises and falls.

You don't necessarily want a higher gamma (and all that comes with it) though, even if you're hoping to cash in on big move from an underlying stock or index. In most cases, higher gammas coincide with lower-cost options that ultimately gives you more bang for your buck, but these options are barely in the money or even out of the money, and as such are riskier. Higher gamma values also coincide with lower beginning deltas, even if that delta is apt to improve over time. The key is finding the ideal balance for your particular trade.

The easiest way to get a grasp on gamma is with an actual example. So, let's go through a side-by-side comparison of how gamma identifies changes to an Amgen (AMGN) calls' delta through a series of different - and progressive - price scenarios for Amgen shares themselves.

As our baseline pricing model while Amgen shares are trading at $249.17, the 245 calls expiring a month from now are worth $7.68 (or $768 per contract). More importantly, delta is $0.61, meaning for every point Amgen shares rise or fall, this particular option will gain or lose (respectively) $0.61 worth of value. The delta value isn't static though. Most important of all for us right now, for every dollar Amgen shares lose or gain in value, the option's delta will grow or weaken by $0.03. That's what the gamma figure at the bottom of the table tells us.

We can use our option-pricing calculator to test and verify this assumption. Changing nothing else but the stock's price and pushing Amgen's price up one point to $250.17 drives the delta value up $0.03 to $0.64.

That still leaves the gamma figure at $0.03, so another test of gamma's predictive power, let's scoot the price of Amgen up another $1.00 to $251.17. Here delta has improved another $0.03 to $0.67.

So at what point might the gamma change? Actually, the next step of our test gives us our first change in gamma. With shares of Amgen priced at $252.17, the delta only improves by $0.02 to $0.69, jibing with our new gamma estimate of $0.02.

Of course, one must also notice that as delta grew as prescribed by gamma, so too did the price of the call in question.

It works the other way too. If instead Amgen were to lose one point of value from our starting point of $249.17, falling to $248.17, our delta of $0.61 would sink to $0.59....$0.02 lower. That isn't the $0.03 change gamma would have predicted, but we can chalk this up to rounding.

The $64,000 question: So what? We now know what gamma is, but is it even worth considering? If so, how?

Admittedly, it's easy to suffer from "paralysis analysis" when you're trying to doing something constructive with a Greek, or in the case, a Greek of a Greek. At some point traders have to accept there are just going to be some unknowns and unpredictable factors that they simply have to live with.

There's still value for many traders in considering gamma though. In particular, a small army of traders known as gamma scalpers must understand these ins and outs.

The short explanation of gamma scalping is, astute traders can identify mismatched gamma values where a change in the price of an underlying stock or index does more good for one option than it hurts the value of an opposing option. Gamma scalping is also a way of capitalizing on a stock's growing or shrinking volatility. Yes, all the Greeks change in value with a stock's volatility, even if nothing else with a stock or its options change.

Gamma can also help you identify which options are most sensitive to changes in volatility or when the theoretical volatility isn't in line with a stock's actual volatility. In a similar sense, gamma can help traders sidestep the downside of theta, or time decay. The higher the gamma (usually) the higher the theta. It's possible one or the other is miscalculated though, translating into an opportunity to capitalize on the market's mistake.

Still, isn't gamma too much for traders to process, particularly given that it's a theoretical value subject to change due to factors beyond the quantifiable -- like a stock's price change -- anyway? Never even mind the fact that gamma values are already reflected in better-understood data points like theta.

It's true that some traders won't use gamma, and won't be worse off for it. Nevertheless, it's something to work into your trading repertoire. The best way to learn it is simply notate changes to gamma and delta for your option trades, and watch how they change over time. It's also helpful to "paper trade" other options that you didn't trade to see if there was something gamma would have told you that would have been more helpful beforehand. This of course assumes you're keeping a trading journal, which of course you should.

If you're ready to take your use of gamma to the next level, BigTrends offers an intensive but digestible Gamma Options Boot Camp course. This four-session online course explains all the ins and outs of gamma, and how you can use them the BigTrends way for building better profits. Go here to learn more.

Or, if you'd rather someone do the trade-picking for you, our Options Shark alert service relies heavily on optimizing the use of gamma in options trading. Many subscribers say they've learned a great deal just by studying the Options Shark service's trades. Check it out.