Options Gamma Trading Introduction
Options gamma is all about showing you the rate of change of the options delta. Therefore, it is the rate of change of the rate of change.
I will explain what exactly options gamma trading is and how to implement it to your trading strategy.
Before you begin, you will want to read all about options delta in this article.
What is Options Gamma Trading?
Options gamma is measured as the rate of change of the delta. As you will recall, the delta is the value change of an options contract given a $1 change in the underlying stock, or security.
But does delta change equally for every $1 move? It is a little more complicated than that, as the price is not linear.
In fact, for every $1 move of stock, the delta value changes for the next $1 move. Delta constantly morphs and changes in real-time. This change is measured using Gamma.
Now you might be a little confused, and that is the perfect place to be at this point.
Let’s look at an example to illustrate the point more clearly.
Options Gamma Trading – Call Option Example
Imagine you own a $25 call option for a stock that is currently trading at $25 per share.
The call option would have a delta value of around 0.50 as it trades very close to the market price of the stock. If you want to understand why this happens, click here to read the options delta article here.
Looking at the curve below of this example, you will notice that the gamma (blue line) is highest near the stock price at $25 per share. This is also the strike price.
As the stock price market value moves away from the strike price, the gamma decreases at the same rate in either direction.
Critical concept #1: options gamma is the highest when the strike price is equal to the stock price.
The red line represents the call delta price, which has the steepest slope in the zone with the highest gamma. This makes sense because the rate of change is the highest (gamma) when the strike is close to the market price.
Critical concept #2: a $1 stock move will cause the highest change in your profit or loss when you own a strike price contract closest to market value.
Next, let’s take a look at how options gamma trading is impacted by the time value of an option contract.
Options Gamma Trading – Gamma vs Time
Now you know when options gamma will create the largest gains or losses in your options contract. Let’s study the relationship between gamma and time.
Below you can see a graph of options gamma versus the days to expiry of your options contract.
You will notice that the lowest time to expiry (dark blue line) has the sharpest options gamma. The longer time to expiry options has lower gamma near the at the money strike.
Critical concept #3 – the less time to expire your options contract has, the higher the gamma. Therefore, the larger your profit or losses will be for a $1 move of the underlying stock.
There is a very simple explanation for this concept.
With less time to expire, there is less opportunity for the stock price to make a move in your favor or against you. That is, moves are more permanent as you get closer to expiry.
Options Gamma – Which Option is Right for Your Trading?
Now that you understand options gamma, let’s talk about applying this concept to your trading strategy.
Let’s assume that you think Apple stock will move $10 a share in the next 4 weeks based on your technical analysis. Apple is currently trading at $148 per share.
You would want the largest gamma stock option to realize the largest return for your investment.
Therefore, you would want to buy a call option with 30 days time value (to have enough time to realize your 4 weeks price target).
Besides, you would look for the strike price that is closest to the stock market value (called at the money).
Currently, this would be the $150 strike February 8th, 2019 call option. This has 34 days to expiry. You are paying $9.00 per contract or $900 in total.
This contract would give you the largest delta profit, as well as the largest increase of delta in the future (which is gamma).
If you understand this concept, you have perfected the concept of options gamma trading.
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The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable for your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.