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Derivative contracts such as futures and options allow traders to use various strategies in the stock market to reduce risk and maximise returns. Future and option trading or F&O trading requires traders to take certain positions by taking into consideration all the factors that can influence the price. To be able to do this strategically, when it comes to options trading, traders rely on a set of metrics that measure risk. These metrics are named after Greek letters – vega, theta, delta, and gamma – and are called Option Greeks. Option Greeks allow traders to assess market volatility and the option’s sensitivity to it. Hence, each of these option Greeks is helpful. But today, let’s take a close look at gamma.
What does gamma do?
To understand what gamma does, we first need to look at delta. As you know, the stock market is volatile, and the price of securities keeps changing. As the price of the underlying asset changes, so does the price or premium of the option. The option Greek delta measures this change in the premium of an option. It is measured from -1 to 1.
Now, gamma is a metric that is used to evaluate delta. What this means is that gamma measures the rate of change of delta over time. If you are wondering why we need another metric to measure delta, that’s because delta’s value keeps changing constantly with the changes in the price of the underlying security. Traders need to have some stable metric that can help them get a sense of what to expect and make decisions accordingly. That’s where gamma comes into the picture – it represents delta’s rate of change or the movement risk.
Consider there is a call option on an underlying stock with a delta of 0.3 currently. Now, if there is a change in the value of the underlying stock, say the price increases by Rs. 100, the option value will also increase but by Rs. 30. Let’s say that this price increase causes the delta of the option to change to 0.45. The gamma here, then, would be the difference between the initial delta of 0.3 and the new delta of 0.45 and would hence be 0.15.
How to use gamma for options trading
The two important factors that impact gamma are the time to expiry and the price volatility of the underlying security. Gamma values are highest for at-the-money (ATM) options and lowest for out-of-the money (OTM) options. When you visualise gamma as a curve, it will be a bell-shaped curve when there is low volatility, and it will be comparatively flatter in case of high volatility. The value of gamma is positive or negative depending on your option position – it is positive for long positions and negative for short positions.
Since gamma essentially helps measure the degree of stability or instability of delta, a higher gamma can indicate a higher change potential in delta which may point at the delta’s instability. However, when using such metrics for trading in the market, it’s crucial to look at them together to get a whole picture instead of assessing them in isolation.
