Show pageOld revisionsBacklinksBack to top This page is read only. You can view the source, but not change it. Ask your administrator if you think this is wrong. ====== Gamma ====== Gamma is a crucial measure in the world of [[options]], one of the five "[[Greeks]]" used to manage the risk of an options portfolio. Think of it as the //acceleration// of your option's value. If an option's [[delta]] represents its "speed"—how much its price changes for every $1 move in the underlying stock—then gamma measures how much that speed (the delta) changes. In short, gamma tells you the rate of change of an option's delta. A high gamma means your option's delta is highly sensitive and can change dramatically with even small movements in the stock's price, making your position more volatile and unpredictable. A low gamma implies a more stable, slow-changing delta. For traders, gamma is a double-edged sword: it can rapidly amplify gains but can just as quickly accelerate losses. ===== Why Should a Value Investor Care About Gamma? ===== You might be thinking, "I'm a [[value investor]], I buy great companies at fair prices and hold them for the long term. What do I care about the hyper-speed world of options trading?" It's a fair question. While value investing focuses on a company's intrinsic worth, not short-term price wiggles, understanding concepts like gamma is about smart risk management. Some value investors use options to enhance their portfolios, for instance, by selling [[covered calls]] to generate extra income from their long-term stock holdings. In this scenario, you are "short" an option, and you are exposed to what's known as **Negative Gamma**. This means the risks in your position can accelerate against you if the stock price moves sharply. Understanding gamma helps you recognize and manage this risk, ensuring a secondary income strategy doesn't accidentally blow a hole in your carefully constructed portfolio. It's about knowing the tools available and, more importantly, the dangers they can carry. ===== Decoding Gamma in Action ===== ==== The Mechanics of Gamma ==== Gamma isn't a constant; its value changes based on a few key factors, primarily the stock's price relative to the [[strike price]] and the time until expiration. * **Moneyness:** Gamma is at its absolute highest when an option is [[at-the-money]] (ATM), meaning the stock's current price is very close to the option's strike price. Here, the outcome is most uncertain—will it expire worthless or with value? As the option moves deep [[in-the-money]] (ITM) or far [[out-of-the-money]] (OTM), gamma drops significantly because the outcome becomes more certain. * **Time to Expiration:** Gamma gets more powerful as an option approaches its expiration date. This is because there's less time for the stock price to meander, so any small move has a much bigger impact on the option's delta. This rapid increase in gamma close to expiration is sometimes called a "gamma trap" for the unprepared. Let's imagine a [[call option]] has a delta of 0.50 and a gamma of 0.10. If the underlying stock price rallies by $1, the gamma of 0.10 is added to the old delta. The option's new delta will now be approximately 0.60 (0.50 + 0.10). Your position is now more sensitive to the next $1 move! ==== Positive vs. Negative Gamma ==== Every options position has a gamma, and whether it's positive or negative tells you a lot about your risk profile. * **Positive Gamma:** When you **buy** a call or a [[put option]], you are "long gamma." This is generally a good place to be. It means that as the stock moves in the direction you want, your delta increases, accelerating your profits. If the stock moves against you, your delta decreases, slowing down your losses. The risk for a buyer is simply limited to the [[premium]] paid for the option. Your gains are amplified, and your losses are cushioned. * **Negative Gamma:** When you **sell** (or "write") an option, you are "short gamma." This is a much riskier position. It means that as the stock moves against you, your delta also moves against you, accelerating your losses. For example, if you sell a call option and the stock price soars, your negative delta becomes even more negative, exposing you to potentially unlimited risk. This is the core of [[gamma risk]] and why selling "naked" options is considered one of the most dangerous strategies in finance. ===== The Investor's Takeaway ===== For the prudent investor, gamma is less a tool for speculation and more a risk-o-meter. Here's how to think about it: - **Be Wary of High Gamma:** High gamma means high instability. As a value investor, you prize stability and predictability. Be cautious with strategies involving at-the-money options that are close to expiring, as their behavior can be erratic and is the opposite of a long-term, fundamental approach. - **Understand Negative Gamma Risk:** If you ever consider selling options (e.g., covered calls), you must respect the power of negative gamma. It creates an unstable risk profile where losses can quickly spiral out of control. Always understand your maximum potential loss before entering such a position. - **A Barometer for Volatility:** Even if you never touch an option, knowing that a stock is the subject of intense, short-dated options trading (a high-gamma environment) can help explain why its price might be unusually volatile. It's another piece of the puzzle in understanding market behavior.