Option Greeks Explained: Gamma
Earlier, we covered the option greek “Delta“, which measures the change in a positions value with respect to a $1 move in the underlying. As the “delta” of an option gets closer to +/-100, it behaves more and more like a stock – meaning that it moves $1 for $1. To push delta towards +/-100, we have gamma, the rate of change in delta.
- Long calls/puts have a positive gamma
- Short calls/puts have a negative gamma
Starting Delta + [+/- $ move * Gamma] = New Delta**
Example: Let’s say you are short a call option (ITM) with a delta of -60 and a gamma of -10. As the underlying falls by $1, your position will make $60 [-$1*-60] and this is where gamma comes into play. It recalculates the new delta for the position, which now becomes -50 [-60+(-$1*-10)], so as the underlying moves down by another $1, the position further profits by $50.
On the other hand, if the underlying initially rises by $1, the position will lose $60, but the new delta for the position will become -70 [-60+ ($1*-10)]. Thus, another $1 move up by the underlying will result in a further loss of $70.
One easy way to check your “New Delta” calculation is to verify the direction of “delta”. Remember that as call options move ITM, delta gets closer to +/- 100. In the case of a short call, as the stock moves up it gets closer to being ITM, thus delta should be getting closer to -100; check for yourself above!!
So why do you need to know gamma?
Gamma allows you to calculate your risk!! I intentionally provided an example of a short option because its important to know what you can lose since short options have unlimited risk. When a short position goes against you, gamma can accelerate the loss. But, the opposite is true for long positions, where gamma can magnify your profits!!! So use gamma as a risk management tool.
And this is the magic of GAMMA!! As a beginner, DO NOT worry about the Option Greeks too much as it will take some time/practice to understand their impact.
