They are:
Today we’re going to talk about gamma, often called “delta of delta”. We know that delta measures an option’s sensitivity to changes in the underlying asset’s price. A $1.00 move in the underlying becomes a $0.30 move with a chance of delta 0.30. Simple enough.
Gamma works similarly. Gamma measures the sensitivity of Delta to price changes of the underlying asset. An option with a delta of 0.30 and a gamma of 0.03 will have a delta of 0.33 when $1.00 moves in the underlying.
Importance of gamma
Without proper context, gamma might seem like an exciting metric, much like a very specific stats announcer likes to cite when watching football. , throw interceptions twice as often when targeting defensive backs whose last names start with ‘B’. It’s funny but does it matter?
The gamma of an options position has a significant impact on how the P&L evolves over the life of the position. Positions with positive gamma have very different characteristics than positions with negative characteristics.
To give a little background, Goldman Sachs has this to say about gamma:
Gamma – the potential delta hedging of option positions – is one of the more prominent sources of non-fundamental economic activity in global markets.market maker Delta-hedged option positions are economically viable to trade a substantial amount of the underlying stock or futures as a result of changes in the price of the underlying asset itself, regardless of available liquidity, rather than as a result of fundamental news. is driven by As a result, gamma can cause the market to overreact to important news (“short gamma”) or underreact to important information (“long gamma”).
Sometimes gamma plays a large role in option positions, while other times it is relatively insignificant. Understanding gamma and how it interacts with other Greeks is essential to knowing when P&L is driven by gamma.
Like delta, it can have a positive or negative gamma position. The favorable gamma position is often called “long gamma” and the negative gamma is called “short gamma”.
What is a Long Gamma Option Position?
If the option position’s gamma is positive, the trader is long gamma. This includes being a net long option.
Most non-professional options traders live in a positive gamma arena. Positions such as outright long calls and puts and vertical debit spreads are classic examples of long gamma trading.
As a rule of thumb, long gamma positions are often short theta. That is, it suffers from negative carry for theta decay.
As a result, long gamma positions will benefit greatly from strong trending markets, while sideways range bound markets will slowly see profit/loss shrink due to theta decay.
Unlike short gamma positions, the total exposure in long gamma positions increases when the trade is correct. For a long call (a favorable gamma position) the trade is correct and the delta increases.
This component of long gamma positions makes them much easier to manage than short gamma positions. It’s psychologically easier to manipulate a position if it only increases your exposure if you’re already making money. As long as you size your position correctly, you don’t have to worry about it getting out of control. And if you are right, you can reap great rewards.
short gamma
Let’s say you’ve been involved in online options trading discussions on Twitter, Reddit, etc. for the last few years. If so, you’re probably already familiar with short gamma positioning, which causes the universal “gamma squeeze.”
Short Gamma is a net short option with all the advantages and disadvantages of selling options.
ie:
- Benefit from low volatility and flat price action
- Exposure grows in the wrong direction (wrong makes your position more noticeable)
- Generally concave payoff profile (limited gains due to larger loss potential)
- Vulnerable to “Gamma Squeeze”.
- Advantages of theta decay
What is Gamma Squeeze?
Gamma squeeze is a whole other subject than identifying the pros and cons of gamma levels in option positions, but explaining it explains the power of gamma.
A gamma squeeze occurs when many traders (mainly market makers) find themselves in short gamma positions during a sudden burst of market volatility. Market makers are forced to quickly adjust their delta hedging, which further accelerates the rally and creates a feedback loop.
Basically, options traders have guessed two things about options market makers:
- they are often short gamma
- They systematically delta hedge
The logical follow-up here is that if a market maker is very short gamma and a sharp move occurs, the hedge reaction will create a feedback loop, continuously driving price in the direction of the trend. It means to push up.
Here’s how it works in theory.
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Market makers typically choose short gamma and short options because clients tend to choose long options for hedging and speculative purposes.
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This is exaggerated in stocks favored by retail traders who prefer OTM calls with a high gamma, requiring market makers to keep their gammas very short.
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So you already have a hotpot, and Catalyst is entering the market, creating a call-buy frenzy.
- Rapid price movements in the underlying asset force market makers to adjust their delta hedging, which further accelerates the rally and creates a feedback loop.
final thoughts
The gamma squeeze example may be a bit of an overstatement these days, but it perfectly illustrates the importance of understanding gamma in options trading. This is a real-world example of the power of gamma and the types of market movements it can facilitate.
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