Gamma in Options Trading: 3 Strategies to Consider

If you have some experience with options trading, you may have come across the four Greek letters delta, gamma, vega and theta. Professional options traders look at these Greek letters before entering positions. These four letters help traders determine whether an option position is a good choice and whether it’s likely to become profitable. While these Greek letters seem to add an extra layer of complexity, they aren’t too challenging to master. This article will explore how gamma works in options trading. It’s a subtle Greek letter that beginner options traders overlook, but it can have significant ramifications for an option’s value.

What Is Gamma? 

Before knowing what gamma is, it’s important to know delta because of how those Greek letters are correlated. Delta measures how much an option’s value will change if the underlying stock goes up or down by $1. Delta ranges from negative 1 to 1. Zero serves as the midpoint, while negative numbers are bearish and positive numbers are bullish. 

Delta is a theoretical value that can change if the stock market becomes more volatile or after a company releases earnings. Gamma measures how much delta can change based on price movements in the underlying stock. It’s similar to the compound effect but for option valuations. A high gamma can indicate higher volatility than usual and tip you off on an options contract set to move sharply in either direction.

How to Calculate Gamma

An options trader can calculate gamma by dividing the change in delta by the underlying share price. Unsurprisingly, this can get tedious if you manually perform this calculation for several stocks, and price fluctuations in the underlying stock mean the gamma constantly changes. Most options traders rely on software that provides real-time data on gamma and the other Greek letters to save time. It’s easier to do it this way and gives investors more time to research stocks and perform technical analysis for short-term trades.

Example of Gamma

Imagine a stock trading at $100 per share. A trader can purchase a call contract for this hypothetical stock with a 105 strike price that expires in a few weeks. The trader pays a $2 premium for this option, meaning the stock must reach $107 per share on expiration to break even. The option has a delta of 0.60 and a gamma of 0.05. 

Because of a strong day at the stock market, this $100 stock becomes a $101 stock at the end of the day. Delta works on the option contract’s value, increasing it from $2 to $2.60, representing a 30% gain. Since the stock went up $1, and gamma is set to 0.05, the option’s delta rises from 0.60 to 0.65. If the stock moves up $1 the following day, the options contract rises from $2.60 to $3.25 ($2.60 current value + 0.65 delta). With back-to-back green days, gamma may increase from 0.05 to 0.07.  Meanwhile, delta is positioned at 0.7 for this rising stock. Gamma continues to influence delta, but delta cannot exceed 1 or fall below negative 1.

How is Gamma Used in Trading

Gamma is a valued Greek letter that is easy to overlook when you are getting started with options trading. But you may use gamma as part of your trading strategy to enter and exit positions. Here are some strategies to consider help turn gamma into your ally.

1. Long Gamma Strategy

A long gamma strategy involves holding onto options and waiting patiently for gamma to influence delta. Traders who use this strategy purchase options contracts with low deltas and wait for those deltas to get higher before selling. Gamma becomes less effective as a delta gets closer to 1.

2. Short Gamma Strategy

A short gamma strategy involves shorting a call or put. A trader shorting a call wants the underlying stock to decrease in value. Every $1 decrease hurts the delta based on the gamma’s value. While traders with short calls wish the underlying stock to fall, traders with short puts wish the underlying asset’s value to rise.

3. Gamma as a Trader's Hedge

Delta can vary drastically as the underlying stock’s price fluctuates. Some traders strive to create a delta-neutral position by hedging for gamma. You can also use this strategy to help protect your position from sharp options price movements that can occur as an option gets closer to its expiration date. A trader with several long-term calls may buy a short-term put that expires in a week to help protect themselves from major volatility. Earnings reports, Federal Reserve meetings and other events can wipe out potential capital gains from other option positions. A gamma hedge can minimize the damage, potentially mitigate any losses or possibly generate a short-term profit depending on how you hedge your portfolio.

Potential Advantages of Using Gamma

Gamma can be a helpful resource for any options trader. Here are some points to consider:

1. Hedge Your Long Options

Using short-term gamma as a hedge can help protect your portfolio if your thesis doesn’t go as expected for your long positions. Options typically become more affordable as they approach expiration. Because gamma rises as expiration draws closer, a sudden shift in your favor can offset some or all of your losses from long positions.

2. Find Gamma Squeeze Opportunities

Looking at gamma can help you find option contracts that can soar in value because of gamma squeezes. While AMC Entertainment Holdings Inc. and GameStop Corp. are famous short squeezes, gamma squeezes are more frequent. A long-term investor may overlook strong movements this Thursday and Friday, but they can help a gamma trader increase returns if a squeeze takes place. Gamma squeezes are volatile opportunities that can result in large losses. Even if you feel confident in a setup, it is best to approach gamma squeeze opportunities with caution.

3. Gamma Trading Gives Traders More Choices

Traders deploy several strategies in an attempt  to increase their returns and get their money to work for them. Understanding gamma adds more versatility to your options trading strategy.

Risks Associated With Gamma

No investment strategy or approach is perfect. Before using gamma for your options trading strategy,  here are some things to keep in mind:

1. Shorting Gamma Is Risky

Shorting any asset can result in unlimited losses if you don’t have any coverage. While long traders can generate returns from gamma squeezes, they can make a dent in a short seller’s portfolio.

2. Gamma Relies on the Underlying Stock

Gamma relies on the underlying stock price’s movement to change delta. If the stock price stays flat, gamma won’t take effect, and the option contract’s value will gradually decline.

Incorporating Gamma into An Options Trading Strategy

Gamma is a popular Greek letter among options traders. Knowing gamma’s value helps traders understand how delta can change based on every $1 increase or decrease of the underlying. While delta and theta are two of the most popular Greek letters, using gamma can help you hedge against short-term risks and tap into more gains.

Frequently Asked Questions