In regards to options, the Greek letter, Gamma, indicates how much the Delta will change given a $1 change in the underlying security.
Delta shows how a $1 change in the underlying security affects the option’s price. The Gamma is used to show how the Delta might change with that same $1 move.
This article will explain what Gamma is, and how to find it using a simple theoretical example. Understanding Gamma will be helpful in bettering one’s own option trading skills.
Gamma is used to try and gauge the price movement of an option. Gamma approaches zero when the option that is being measured is deep “in-the-money” or deep “out-of-the-money.” Gamma is at its highest when the option that is being measured is near or “at-the-money.”
A high Gamma value indicates a higher risk in the option. Options that are “at-the-money” are unpredictable as they have a similar chance of expiring “in-the-money” as they do “out-of-the-money.” A low Gamma value indicates a lower risk. Options that are far “in-the-money” or far “out-of-the-money” are more predictable and will most likely expire where they are at.
Let’s look at an example of how to find the Gamma value.
- Assume Stock XYZ has a value of $20. An XYZ call option has a Delta of .50 and is priced at $1. The stock value increases to $21. The option price increases to $1.50. Now that the option has a new price, the Delta value changes. If the Gamma of this call option is .08, then it can be expected that the Delta on the new option price will be .58. The change in the Delta value is the Gamma.
After having read this article, one understands that Gamma gives a good indication of how close an option is to being “in-the-money,” “out-of-the-money,” and “at-the-money.” One should also understand how Gamma gets its value. This is important because now an investor can see how much risk is involved in certain options before trading those options.
