Gamma is yet another Greek, one that we don’t examine quite as closely as the others, but it is still important. Gamma represents the direction and speed in which delta will change per a $1 move in the price of the underlying stock.
In calculus terms, gamma is the first derivative of delta. It is the second derivative to the underlying’s price.
I try to make things not too “mathy” but it’s easier to think about this way. To some people, derivatives make perfect sense. To others (me), it makes more sense to simply be aware that gamma tracks the movement of delta, and delta tracks the movement of the stock.
So if we had a call option with a delta value of 0.75 (which would be in the money, due to the fact that it is greater than 50) and a price of 0.10 gamma, if the underlying moves up $1, the delta of the call would move up to 0.80 (0.75 + 0.10). For a $1 move in the underlying, the delta moves by 0.10, or the value of gamma.
Gamma is normally negative when we are short options, and positive when we are long options. When we have negative gamma, delta tends to move opposite to the underlying (when the stock increases, delta decreases, and vice versa).
So the previous example would be “long gamma” or positive gamma, in which the stock price and delta move in the same direction.
Gamma primarily effected by the amount of time left to expiration, and the strike selection we choose. If we were really close to expiration, with at the money (ATM) options, we would have a very high amount of gamma risk. This is due to the movement that occurs in each of these individual entities. There tends to be quite a bit of bouncing around close to expiration, which increases risk, and the closer you are to ATM, the riskier a small movement in price is. However, if we were further out in both time and position strikes, we would be able to mitigate risk.
That being said, the larger the gamma amount, the larger the change in delta when the underlying experiences a movement.
To reduce overall gamma risk, we look to either roll positions out or close them about 7-10 days to expiration. This is a good rule of thumb to follow even without gamma exposure. The longer we wait to cash in on trades, the more risk we take on, and the less theta decay premium we receive. The overall profit ratio begins to decrease, and it gets to the point where you’re basically playing for pennies, which IS NOT worth it.
Overall, gamma is an important Greek to be aware of, but I personally don’t base my trades of gamma values. I look instead to delta, and that key 45 days-to-expiration window. However, it’s important to take note of gamma, especially as expiration cycles begin to near their close. So the basic key take-away? Be aware of everything, but pay attention to only the “important” things.
Disclaimer: These views are not investment advice, and should not be interpreted as such. These views are my own, and do not represent my employer. Trading has risk. Big risk. Make sure that you can balance your risk/reward, and trade small, and trade often.