The first think that a trader would think of when “hedging” is mentioned is limiting risk exposure. That is exactly what Gamma hedging eludes to, a strategy used to mitigate or even eliminate risk created by option delta.
Gamma hedging is an options strategy, for more information on Delta hedging, click here to check out our article!
Gamma Hedging-Gamma Introduction
What is gamma? Lets review the topic of gamma before we get too complicated. Gamma is a Greek symbol often associated with options trading. It represents the rate of change in a given option’s delta. While delta is the change in the options value related to the change in an underling assets change in price.
Confused? Well you could think of the options gamma as the second derivative of the underlying assets change in price, while delta is the first derivative. For a thorough explanation on options gamma check out our in depth article, click here.
In short, long options whether call or put should have a positive gamma, while short positions a negative gamma. The further out of the money the strike is, the lower gamma. The closer in the money an options strike is the higher the gamma.
Gamma Hedging- Limiting Exposure.
The basis of the gamma hedge is re-adjusting a delta hedge. A key point is to remember that delta can change and this depends on the change in the underlying asset. Which then is affected by the option’s gamma. Gamma hedging in addition to delta hedging is designed to protect against volatility and time value erosion.
The simplest of gamma hedges involves the initial creation of a delta hedge, because the gamma hedge, to reiterate is used to mitigate volatility risk from the delta hedge.
The delta hedge can be done by entering a long call option position which short the same number of underlying shares. This is a good hedge if volatility drops or stays stagnant, but should volatility rise, there is room for gains but if theta (time) erosion hits the position, it is left wide open for potential losses. This is where the gamma hedge comes in. One would do so by adding short calls to the portfolio at a higher strike. What these short calls do is protect the overall position against time decay and large delta moves.
The two hedge positions are meant to completely eliminate gamma and delta for the underlying shares. The delta hedge would result in a negative delta as the call options are sold to produce premium.
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