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Gamma, An Excellent Timing Tool To Test Option Valuation

The "Greeks" provide a lot of insight about volatility and pricing of options; among these one of the most valuable is gamma. A gamma trade - one based on changes in gamma - gives you a way to time entry and exit to maximize potential return.

An option's gamma is a measurement of how the delta changes in relation to the underlying security. Gamma measures the delta sensitivity to the stock's price movement. Delta is a direct indication of the option value and how it moves compared to movement in stock. So if the delta of an option is 1.0, it means the option tracks stock movement exactly the same. If the option moves at 50 cents for every dollar of movement in the stock, delta is 0.5. (This applies to calls; puts, in comparison, have a negative delta.)

Gamma measures the speed of changes in delta based not only on changes in the underlying but also on the proximity of the option strike to the underlying security market value. The degree of volatility in the option is expressed by gamma, and as it increases, so does the market (or, volatility) risk.

For all long positions, either calls or puts, gamma is always expressed as a positive value and for short option positions, gamma is always expressed as a negative. So for example, if you are long in a call, your gamma becomes longer as the underlying price increases, and shorter as the underlying price decreases. Gamma measures changes in delta and together, gamma and delta are the best tests of how options and the underlying interact. The change doesn't happen for no reason. As proximity of strike to value evolves, so do both delta and gamma. The speed of the change is measured by gamma as a means for identifying implied volatility and timing either long or short trades.

As the option moves toward at-the-money status, gamma is likely to rise as well, reaching its highest point when strike and market value of the security are identical. Gamma declines as the degree of in-the-money and out-of-the-money status increases. This volatility would be easy to spot if it occurred in a pure environment, without the double effects of time value and time to expiration. These affect overall value as well, so measuring delta by itself is difficult since every option's value will change at a speed determined by many influences. Gamma provides a measurement of the overall change in delta, so that you can judge the particular option based on a combined analysis of expiration and proximity.

The significance of gamma, like all of the Greeks, relies on how it is applied. Traders using options, especially in complex straddle and spread combinations, may have difficult deciding the overall position volatility. Components of advanced strategies cannot be quantified easily, but the combined position delta and gamma may help to estimate exit levels, either for entire positions or for legs of those positions.

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