There is a lot of confusing greek terminology in options trading. Hope that yesterday’s article about Delta cleared about some confusion, but we’ve got more coming! Let’s talk about gamma, and what you need to understand about it to trade options successfully:
What is Gamma?
An option contract’s gamma is simply a measure of the rate of change of its delta. The two go hand in hand. The gamma measures the rate that delta changes based on a $1 change in the underlying stock price. Options contracts with high gamma are very responsive to changes in the price of the underlying contract. Contracts with low gamma are not very responsive to change in the stock price.
Let’s look at the Delta and Gamma of stock, and an options contract with a strike price of $50:
You can see how when the contract is further from expiration has much lower gamma because the delta only shifts from .32 to .40 when the stock goes from $48 to $49 per share, .1 from $49 to $50, and so on.
But when the contract is 1 day from expiration, the volatility in the option price significantly increases. The same $1 move from $49 to $50 causes the delta to go from .1 all the way to .5. This is because as expiration approaches, the underlying stock has less time to move above or below the strike price in the contract.
Why It Matters
If you’re an option contract buyer, high gamma is a positive thing for your position assuming that your prediction is correct and your contract stays in-the-money. When your contract is in-the-money, the contract’s delta will approach 1 more rapidly, causing it to appreciate in value more.
But if you’re incorrect in your position, high gamma is a very bad thing for your position. The high gamma will cause your position value to decrease at an increased rate if the option you’ve sold moves in-the-money. Always be aware of how an options contract's delta and gamma changes as it approaches expiration.
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