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You should know by now that there are several factors that affect price when trading options – not just the price movement of the underlying asset.
The variables that exist that account for the fluctuations of an option's price movement are known as the options "Greeks," and we've covered many of these – theta, a measurement of options time decay; delta, how an option's price will move with price movements in the underlying; and vega, how sensitive an option is to the implied volatility associated with the underlying.
I've told you that delta is the single most important factor in determining an option's price. Today's Greek shares a special relationship with the delta, measuring the rate of change in the most important component in an option's price.
I like to call it the "delta accelerator."
Here's what I'm talking about…
Where delta shows how much an option price will increase with the next $1.00 move in a stock, gamma measures how fast the delta of that option price will increase after that $1.00 move in the stock.
Let's take a look at a hypothetical situation…
Say you are looking at a stock trading at $45.20. You expect the stock to move higher, so you target a $45 call option. The $45 call is priced at $2.00, with a delta of 0.52 and a gamma of .05.
Here is how things theoretically would work on a $1.00 upward move on the stock…
The stock goes up to $46.20. On delta alone, the option will go up to $2.52 (option at $2.00 + delta of 0.52 = $2.52).
When the stock goes up another $1.00 to $47.20, the delta now becomes 0.57. That increase is represented by the gamma of 0.05 (0.52 + 0.05 = 0.57). The stock should then go higher by this $0.57.
When the stock goes up another dollar to $48.20, what happens to the delta? If you added 0.05 to the delta of 0.57, you should come up with 0.62 (0.57 current delta + gamma of .05 = 0.62).
Understanding the Gamma-Delta Relationship
Delta and gamma are the only two Greeks that are related to each other. Gamma is the only Greek that directly affects or determines the change of another Greek.
Delta is the single most impactful determinant of an option's value. But the delta isn't static – as we've seen, the delta of an option changes dynamically along with each change in the stock price.
The gamma of an option helps us measure the magnitude at which the delta changes.
Gamma is important for both directional and non-directional or hedging strategies. Since a large part of what I do is straight directional trades (such as long call and long put trades), we'll narrow our focus to a long option strategy.
Gamma is the same for both calls and puts, and when you are long either, gamma will be a positive number.
Gamma is going to be highest when the option is at the money (ATM). ATM options will have a delta of +/- .50 (+0.50 for calls and -0.50 for puts), and gamma will always be the highest on the ATM options.
Gamma gets smaller the further in or out of the money the option goes.
The long option (call or put) has positive gamma. As long as the stock goes in the needed direction, gamma, though decreasing, will still result in the delta increasing in value, which results in your option increasing in value.
About the Author
Tom Gentile is widely known as America's #1 Pattern Trader thanks to his nearly 30 years of experience spotting lucrative patterns in options trading. Now, he's diving into the biggest market in the world - one that almost no one has heard of before.