Let’s imagine the options market as a vast sea. Options traders are the sailors who navigate these choppy waters, and the metrics they use – such as delta, theta, vega, and gamma – are their compass, sextant, and navigational charts. Today, we’re going to focus on gamma, one of the most important of these metrics.
When you purchase an option, you’re buying the right (but not the obligation) to buy or sell a stock at a set price before a certain date. The change in the price of the option compared to the change in the price of the underlying stock is represented by delta. Now, delta isn’t static, it changes as the price of the underlying asset changes. The rate at which delta changes is known as gamma.
Think of delta as the speed of your ship and gamma as the acceleration. If you’re traveling at a constant speed (delta), then acceleration (gamma) is zero. But when you start to speed up or slow down, that’s when acceleration comes into play.
Gamma tells you how much the delta (speed) will change for every $1 change in the underlying stock’s price. So, if you have a gamma of 0.05, this means for every $1 increase in the stock’s price, the delta (the “speed” of your option’s price change) will increase by 0.05.
For example, if you have an option with a delta of 0.6 and a gamma of 0.05, and the underlying stock’s price increases by $1, the delta will increase to 0.65 (0.6 delta + 0.05 gamma).
The closer an option’s strike price is to the actual price of the underlying stock, and the closer the option is to expiration, the higher its gamma will be. This is because as the option becomes ‘at-the-money’ (when the strike price and the stock price are equal), the option’s price becomes more sensitive to changes in the stock’s price.
Gamma is highest for at-the-money options and decreases as you move towards out-of-the-money or in-the-money options. Imagine it like this: the closer you are to your destination (at-the-money), the more a slight change in speed (delta) can affect your arrival time.
So how does gamma exposure affect the market?
Well, high gamma exposure means that an options trader needs to adjust his or her position more frequently. This is known as gamma scalping. In simple terms, imagine you’re driving your car and the road is becoming more winding and unpredictable, so you need to adjust your speed more often to stay on course.
Market makers, the people who provide liquidity in the market, usually aim for a neutral gamma. They do not want to have to constantly adjust their positions because of market movement. But when market makers can’t maintain gamma neutrality and gamma exposure increases, it can lead to more trading activity as they buy and sell to hedge their portfolios.
So, to use our maritime metaphor again, when the sea is calm and the course is straight, the sailors (market makers) don’t need to adjust their course too much. But when the waters are choppy and the course is winding, the sailors need to adjust their course more often, leading to more activity on the sea.
In summary, gamma exposure in options trading refers to the rate of change of delta, which affects how sensitive an option’s price is to changes in the underlying stock’s price. It influences how often traders need to adjust their positions and, in turn, can stimulate more trading activity in the market. Understanding gamma can be key to navigating the volatile waters of the options market.
I hope this gives you a better understanding of gamma exposure in options trading and how it affects the market! If you want a more in-depth look, it would be beneficial to consider diving into options trading books or online courses.