Gamma (Options Pricing) - Explained
What is Gamma?
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Table of ContentsWhat is Gamma in Options Pricing?How Does Gamma Work?Calculating GammaExample of GammaImportance of Gamma
What is Gamma in Options Pricing?
Gamma is a tool used to measure the rate of an options price changes with regard to the underlying asset. Gamma that is positive is an indication that the trading position is also positive. Contrarily, when there is an upward or downward movement in the underlying assets price, then the position is always of higher value from that of the delta. Key Takeaways
- Gamma is a tool used to measure the rate of an options price changes with regard to the underlying asset.
- Gamma is at its largest when the option under measurement is either near or at the cash.
- Options in a long position have positive gamma and vice versa.
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How Does Gamma Work?
Gamma as a deltas derivative is used to measure options movement price as per the money or the amount of money the option is in. Note that gamma is regarded to be small when the option under measurement is either in or out of the cash. On the other hand, gamma is at its largest when the option under measurement is either near or at the cash. Generally, options in long position have positive gamma and vice versa. Also, note that the delta measure of an option is always valid for a short duration. This means that traders are in a position to get a true picture of how the delta of the option is bound to change with regard to the price changes of an underlying asset. Using a physics version, options delta can be said to be speed whereas the options gamma is the acceleration.
To effectively deal with the complexity of calculating gamma, it will be easier if you used either spreadsheets or software for finance. This will help you to arrive at a precise value during the calculation. The following example shows how gamma is calculated:
Example of Gamma
Assume that the option of a particular stock is 0.4 delta. Also, suppose the value of the stock goes up by $1, then the options value will also go up by 0.40 resulting in delta change. Lets again assume that following the $1 increase, the delta of the option changes to $0.53. This means that the deltas difference of 0.13 can then be taken to be a gammas approximate value.
Importance of Gamma
Gamma can be used to correct issues related to convexity especially when you want to engage hedging strategies. Portfolios of large value require an additional precision when engaging in hedging. In this case, a derivative known as color can be applied. This derivative can be used to measure gammas rate change as well as maintaining the portfolio of gamma-hedged.