Gamma
Categories: Derivatives, Trading
Like the party scene at certain colleges or the curriculum of any Philosophy 101 course, trading in derivatives involves hearing a lot about Greeks.
The first one that usually comes up is delta. This term refers to the amount a derivative's price changes in relation to price of the underlying asset.
So...you're trading options in oil. You have an option to buy oil, expiring two months from now. The spot price for a barrel of oil rises $1. How much will the value of your option change? Answering that question gives you the delta.
Gamma takes the process a step further. Gamma measures the amount delta changes as the price in the underlying asset moves.
Delta isn't a static thing. It doesn't remain the same over the life of an option. If the option is close to in-the-money, changes in price have a big impact on the option's price. If you have an option to buy 100 barrels of oil for $70 per barrel and the price is sitting at $69.90...an increase of $1 takes that option out-of-the-money to into-the-money. A loser becomes a winner. Big swing in the option's value.
However, if the current price is sitting at $63, then an increase of a $1 doesn't really matter. You have an option at $70 and, with the increase, the price is just at $64. Still way out of the money. Your option still has a long way to go to pay off.
Think of it like betting on a sport. The Warriors and the Rockets are facing each other in Game 7 of the NBA Western Conference Finals. You've bet on the Rockets to win. (You bet the money line, so it only matters whether they win or lose...no point spread in play.)
It's 120-120 with 30 second left. The Rockets score. Now, it's 122-120 with 0:08 to go. How do you feel about your bet? It's looking pretty good. Suddenly, the Warriors sink a three-pointer. Now, they're up 123-122 with 0:01. Suddenly, your Rockets bet doesn't look so promising. Big drop in value on a relatively small change in score.
Different scenario: still 30 seconds left, but this time the Rockets are up 120-93. The Warriors sink a three-pointer. The score becomes 120-96 with 0:04. The three-pointer didn't impact the value of your bet much. The Rockets are so far ahead, it didn't matter. You're just as likely to win now as before. Same three-point change as before, but the impact on your bet's perceived value is different because of the circumstance.
That's gamma. It measures how much delta changes as the price of oil (or whatever asset forms the basis of the derivative) changes.