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Gamma (Γ): Sensitivity to Delta Changes

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Gamma (Γ): Sensitivity to Delta Changes

In the world of options trading, one of the most critical aspects traders focus on is how sensitive their position is to various market changes. One of the “Greeks” that help traders understand this sensitivity is Gamma (Γ). If you’ve been trading or learning about options, you probably know a little about Delta (Δ), which measures how much an option’s price will change when the underlying stock moves by ₹1. However, Gamma takes this a step further by measuring how Delta itself changes as the stock price fluctuates. This may sound complicated, but let’s break it down into simpler terms, explore its implications, and look at a real-world example.

What is Gamma (Γ)?

At its core, Gamma tells you how stable Delta is. Think of Delta as a car’s speed and Gamma as the acceleration or deceleration. Delta represents the change in the price of the option for a ₹1 change in the price of the underlying asset (such as a stock). But Delta doesn’t stay constant—it changes as the stock price changes. That’s where Gamma comes into play. It measures the rate at which Delta changes when the stock price moves.

  • High Gamma: Indicates that Delta will change rapidly, meaning the option price can become more volatile as the underlying stock moves.
  • Low Gamma: Indicates that Delta will change slowly, making the option price more stable.

Why is Gamma Important?

Gamma is crucial because Delta is not a fixed number; it fluctuates as the stock price moves. This is especially important for traders who are trying to manage their risk. Since Delta can change quickly, it can make an options position much riskier than initially expected. Gamma helps traders predict how much Delta will change for every ₹1 move in the stock.

High Gamma and Low Gamma

  • High Gamma means that a small move in the stock price could cause a significant change in Delta. This usually happens when an option is at the money (ATM), where a small change in the underlying stock price can dramatically affect the option’s likelihood of finishing in or out of the money.
  • Low Gamma means that Delta is more stable. When an option is deep in the money (ITM) or far out of the money (OTM), Gamma tends to be lower. In these scenarios, changes in the stock price don’t significantly impact Delta.

Gamma’s Behavior: ATM, ITM, and OTM

Gamma behaves differently depending on whether the option is at the money (ATM), in the money (ITM), or out of the money (OTM).

  • ATM Options: These options have the highest Gamma. Why? Because any small movement in the stock price can push the option either in or out of the money, leading to a significant change in Delta.
  • ITM and OTM Options: These options tend to have lower Gamma. When an option is deep ITM, Delta is already close to 1, so there’s less room for it to change. Similarly, when an option is far OTM, Delta is close to 0, meaning the option has little sensitivity to stock price movements.

Here’s a table to illustrate how Gamma behaves in different scenarios:

Stock Price (₹)Option Strike Price (₹)Option StatusDelta (Δ)Gamma (Γ)
100100ATM0.50.1
10090ITM0.80.05
100110OTM0.20.03
  • In the ATM example, when the stock price is ₹100 and the option’s strike price is ₹100, Delta is 0.5, and Gamma is 0.1. This means that for every ₹1 move in the stock, Delta will change by 0.1, so a ₹1 move up in the stock price would increase Delta from 0.5 to 0.6.
  • In the ITM example, with a stock price of ₹100 and an option strike price of ₹90, Delta is higher at 0.8, but Gamma is lower at 0.05. This means Delta changes more slowly for each ₹1 move in the stock.
  • In the OTM example, with a stock price of ₹100 and a strike price of ₹110, Delta is low at 0.2, and Gamma is even lower at 0.03. This indicates that the option price is less sensitive to stock price movements.

Practical Example: Understanding Gamma in Action

Let’s say you purchase a call option with a Delta of 0.5 and a Gamma of 0.1. If the stock price increases by ₹1, the Delta will change from 0.5 to 0.6. If the stock price increases by another ₹1, the Delta will increase again, this time to 0.7 (0.6 + 0.1). This compounding effect means that small stock price movements can quickly escalate the sensitivity of the option to further stock price changes. This is why Gamma is so important—it helps traders understand how quickly their position could become more volatile or less sensitive to stock price movements.

Now, let’s extend this scenario to consider multiple price moves:

Stock Price (₹)Delta (Δ)Gamma (Γ)Delta After ₹1 Move
1000.50.10.6
1010.60.10.7
1020.70.10.8
1030.80.10.9
1040.90.11.0

In this example, after the stock price moves from ₹100 to ₹104, the Delta has increased from 0.5 to 1.0. A Delta of 1.0 means that the option is now moving almost in perfect sync with the stock. If you didn’t pay attention to Gamma, you might have underestimated how quickly your option would become this sensitive to stock price changes.

Managing Gamma Risk

For professional traders, managing Gamma is just as important as managing Delta. High Gamma can make an options portfolio very sensitive to rapid changes in the stock price, which increases the risk of large swings in the value of the portfolio. Conversely, low Gamma can mean the portfolio is relatively stable, but it might not respond as much to favorable stock price moves.

Traders often adjust their positions to “neutralize” Gamma risk. This strategy is known as Gamma hedging. By doing so, they aim to make their portfolio less sensitive to sharp changes in Delta, thus reducing overall volatility.

Conclusion

Gamma might seem like a complicated concept at first, but understanding it is crucial for options traders. It provides insights into how fast Delta will change, giving traders a clearer picture of their potential risk and reward. In simple terms, Gamma is the sensitivity of Delta to stock price changes. Options that are at the money have the highest Gamma, meaning they are the most sensitive to small stock price movements, while options that are deep in or out of the money have lower Gamma and are more stable.

By mastering Gamma, traders can better manage their portfolios, anticipate risk, and optimize their strategies.

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