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Those are: Delta Theta Vega Gamma Today, we're talking about gamma, which is often described as the "delta of delta." We know that delta measures an option's sensitivity to price changes in the underlying - a $1.00 move in the underlying results in a $0.30 move in a chance with a delta of 0.30. Simple enough. What is Options Gamma? Gamma works similarly. Gamma measures the delta's sensitivity to a price change in the underlying. An option with a delta of 0.30 and gamma of 0.03 would have a delta of 0.33 following a $1.00 move in the underlying. The Importance of Gamma Without proper context, gamma might seem like an exciting metric like those hyper-specific statistics announcers love citing when you're watching football. This quarterback throws interceptions twice as often when targeting defensive backs whose last name starts with a 'B.' Interesting, but does that mean anything? The gamma of an options position has substantial implications for how the P & L will play out over the life of the position. Positions with positive gamma have very different characteristics than those with negative traits. To provide a bit of context, Goldman Sachs said this about gamma: Gamma – the potential delta-hedging of options positions – is one of the more prominent sources of non-fundamental economic activity in global markets. Market makers who delta-hedge their option positions are economically driven to trade substantial amounts of underlying shares or futures strictly as a result of the price of the underlying itself changing, not as a result of fundamental news and without regard to the liquidity available. As a result, gamma can cause markets to overreact to essential news ("short gamma") or under-react to crucial information ("long gamma"). Sometimes gamma can play a huge role in an options position, and other times it's a relative non-factor. Understanding gamma and how it interplays with the other Greeks is vital to knowing when your P&L is driven by gamma. Just like delta, you can have a positive or negative gamma position. A favorable gamma position is often referred to as "long gamma," as negative gamma is "short gamma." What is a Long Gamma Options Position? A trader is a long gamma when his options position has positive gamma. This involves being net-long options. Most non-professional options traders live in the positive gamma arena. Positions like outright long calls or puts and vertical debit spreads are typical examples of long gamma trades. As a rule of thumb, long gamma positions are frequently short theta, meaning they suffer from the negative carry of theta decay. As a result, long gamma positions benefit significantly from strong trending markets, whereas you'll see a slow withering of your P&L in a sideways, range-bound market due to theta decay. Unlike short gamma positions, your total exposure in a long gamma position increases when you're right on the trade. If you're long a call (a favorable gamma position), your deltas will increase as you're correct on the trade. This component of long gamma positions makes them far easier to manage than short gamma positions. It's psychologically easy to work positions when your exposure only grows if you're making money already. So long as you size your positions correctly, you don't have to worry about positions getting out of control. And when you're right, you get paid big time. To enhance the gains, traders might also consider gamma scalping. What is a Short Gamma Options Position? Suppose you've been around online options trading discussions like Twitter and Reddit in the last few years. In that case, you're probably already familiar with short gamma positioning, which is responsible for the almighty 'gamma squeeze.' A short gamma is a net-short option that carries all of the benefits and drawbacks of selling options. A short gamma position is any option position with negative gamma exposure. A position with negative gamma (short gamma) indicates the position’s delta will decrease when the stock price rises, and increase when the stock price falls. Short call and short put positions have negative gamma Namely: Benefits from low volatility and sideways price action Exposure grows in the wrong direction (your position gets more prominent when you're wrong) Generally concave payoff profiles (limited gain for potentially more considerable loss) Vulnerable to "gamma squeezes." Benefits from theta decay What is a Gamma Squeeze? A gamma squeeze is an entirely separate subject from identifying the pros and cons of the gamma level in your options positions, but explaining it can illustrate the power of gamma. A gamma squeeze occurs when too many traders, mostly market makers, get caught in a short gamma position when volatility suddenly comes into a market. Market makers are forced to quickly adjust their delta hedges which further fuels the rally, creating a feedback loop. Essentially, options traders deduced two things about option market makers: They’re frequently short gamma They systematically delta hedge The logical follow-up here is that if a rapid price move occurs while market makers are very short gamma, their hedging response will create a feedback loop, continually pushing the price in the trend's direction. Here’s how that theoretically works. Market makers are generally short gamma and short options because customers tend to be long options for hedging and speculation purposes. This gets exaggerated in stocks loved by retail traders who love OTM calls, which have high gamma, forcing market makers to get very short gamma. So you already have a hot pot, and a catalyst comes into the market, creating a frenzy of call buying. The quick price moves in the underlying forces market makers to adjust their delta hedges, which fuels the rally even further, creating a feedback loop. How expiration impacts Gamma Gamma is higher for options that are at-the-money and closer to expiration. A front-month, option will have more Gamma than a LEAPS option with the same strike because the Delta of the near term options move toward either 0 or 1.00 is imminent. With higher Gamma, investors can see more dramatic shifts in Delta as the underlying moves, especially with the underlying around the strike at expiration. Gamma is lower in the longer-dated LEAPS as more strikes remain possibilities for being in-the-money at expiration because of the amount of time remaining. An at-the-money-option Delta is typically the most sensitive to moves in the underlying (hence higher Gamma). With the stock right at a strike at expiration, an option Gamma will be at its highest as the Delta will be potentially moving from 1.00 toward 0 or vice versa as the underlying crosses a strike. In these cases, the Gamma can be extremely high as the Delta changes rapidly with the underlying at the strike and expiration approaching. Final Thoughts Long option positions (net buying options) have positive (long) gamma. Positive gamma means we add gamma to the position’s delta when the underlying stock price increases, and subtract gamma from the position’s delta when the underlying stock price falls. Short option positions (net selling options) have negative (short) gamma. Negative gamma means we subtract gamma from the position’s delta when the underlying stock price increases, and add gamma to the position’s delta when the underlying stock price falls. The example of a gamma squeeze, even if they might be a bit overhyped nowadays, perfectly illustrates the importance of understanding gamma in options trading. It's a real-life example showing the power of gamma and the type of market moves it can fuel. The Gamma Risk is real, don't ignore it. Like this article? Visit our Options Education Center and Options Trading Blog for more. Related articles Options Trading Greeks: Gamma Explained Why You Should Not Ignore Negative Gamma Gamma Risk Explained Estimating Gamma For Calls Or Puts What Is Gamma Hedging And Why Is Everyone Talking About It? Market Neutral Strategies: Long Or Short Gamma?

An option's terminal value is entirely reliant on the underlying stock's price on the expiration date, making values far more calculable. But crunching some numbers and coming up with a reasonable value for an option doesn’t mean you know how to trade them profitably. The secret sauce is using your understanding of options pricing to predict how it’ll change in the future. Primarily, that understanding comes down to interpreting how the different pricing factors, known as option Greeks, will change with time. The most critical Greeks are Delta, Theta, Vega, and Gamma. And gamma is the worst understood of the Greeks while also holding the potential to be their most influential. What is Gamma? Put simply, gamma measures how fast or slow the delta will change. Options with high gamma values will change far quicker than those with low gamma values. In more technical terms, gamma is the rate of change of delta. Basically, if we have a call option with a delta of 0.20 and a gamma of 0.02, a $1 increase in the stock will increase delta by 0.02 to 0.22. Being long gamma is the same as being long options, as all long option positions have positive gamma, while all short options positions have negative gamma. If you're looking to get on board for a trend in a stock, you want to be very long gamma. High gamma is like a snowball rolling down a hill when a stock is trending. As the stock continues to trend, long gamma positions benefit more and more the longer the trend lasts. This works because as the stock goes up, high gamma pushes delta upwards, making each successive move more significant in terms of P&L. Gamma’s Relationship With Time and Moneyness As a rule, the closer an option’s strike price is to the at-the-money strike, the higher the gamma is. The further out-of-the-money, the lower its gamma. Furthermore, gamma increases as the expiration date of an option approach. To understand this intuitively, take an option at expiration. It either has a delta of 1 (expired ITM) or 0 (expired OTM and thus worthless). Now let's rewind the clock by five minutes. The underlying is at 99.95, and we own the 100 call. This option's fate will be decided in five minutes, resulting in a delta of either 1 or 0. For this reason, it makes sense for delta to move a lot with each price change when we're so close to the money. Gamma Risk: An Introduction Understanding the unique exposure to each Greek pose is one of the building blocks of options trading. It allows you to be more thoughtful when constructing positions. Think of gamma as a horsepower rating for an options position. The higher the gamma, the quicker the option price can change. A little pressure on the throttle of a Porsche 911 can still make a big move. Conversely, putting the pedal to the metal in a 1970s Honda barely gets you to highway speed. To provide context, let's look at two call options in the same stock: one with high and one with low gamma. First, we have a 0.31 delta, 0.031 gamma TSLA 187.5 call trading at $2.14, expiring in one day. With spot TSLA trading at 183, let's look at how quickly the value of this option can change. Keep in mind that this is napkin math. Gamma doesn’t stay constant, nor are we accounting for theta decay or vega here. The point is to demonstrate how gamma can be like rocket fuel for an options position, good or bad. With each price increase, the ensuing price increase is more intense. You'll frequently hear the word "convexity" thrown around in options circles, which is essentially what they mean by that. As Simplify Asset Management puts it, convexity is when an investment payoff is curved upwards. See their graphic below: You can think of gamma as the slope of the yellow curve. The higher the gamma, the steeper that curve will be. The effect of this is that when you make a good call when you're long gamma, your profits increase exponentially the more right you are. In other words, if you own the same Tesla call we referenced earlier, the P&L you make "per tick" increases with each successive tick until you're in-the-money. But just as you can be long gamma and benefit significantly from a runaway trend in a stock, you can also be short gamma. And while it sounds lovely to be long gamma (it's undoubtedly easier psychologically), there are some key benefits to being short gamma. Key among them is that you're shorting options, and most options traders acknowledge that there's an edge in being short options if you do it correctly. Let's return to the same Tesla call option example we just used, except this time, we decide to short the option, leaving us with the exact opposite position. So here's where we're at: ● Delta: -0.31 ● Gamma: -0.031 ● $2.14 (net credit) ● Expires in one day Should we see the same scenario play out, where Tesla rallies aggressively, we'll see the same phenomena occur. As this position goes against us, things just get worse and worse. Bottom Line We continue to hammer home the concept that trade-offs play such a massive role in options trading. Buying options gives us convexity with a defined risk, but we're buying volatility which is overpriced on average, typically giving us a poor win rate. Selling options typically gives us a steadier equity curve with more frequent wins, but we get bit in the rear end when an underlying begins to trend against our position, and short gamma quickly eats us alive. As you develop as an options trader, you learn how each options Greek presents you with these sorts of complex trade-offs and how you can elegantly craft a position to fit your desired exposures very closely. Related articles: Options Trading Greeks: Gamma For Speed Why You Should Not Ignore Negative Gamma Estimating Gamma For Calls Or Puts What Is Gamma Hedging And Why Is Everyone Talking About It? Short Gamma Vs. Long Gamma