Gamma

Gamma is one of the least understood but most powerful of the options Greeks. Gamma is the variable that tracks the rate of change of Delta. In the previous example, we compared Delta to horsepower. Keeping with that same example, Gamma is the acceleration or rate of change of the dragsters. How quickly can each car make use of its available horsepower? That’s Gamma.

Unfortunately, many options investors fail to recognize the effect that Gamma can exert upon the value of an option. In reality, knowing how the Delta changes can make a significant difference in the profitability of an option play. Here’s an example:

Suppose that IBM is currently trading for $23.00 per share. Suppose further that a glance at the options Greeks showed that the current Delta for the $20 strike price option was .96. This means that for every dollar per share the stock price rises, the $20 strike price option will increase $0.96 per share. That’s the current situation, but a quick check of the Gamma value for the $20 strike Calls is 0.04. This means that if the stock were to increase a dollar per share, the Delta would increase by 0.04, resulting in a Delta of 1.00. Once the stock price reaches the level of $24 per share, the $20 strike price options will increase dollar for dollar in value with any further increase in the value of the stock.

Now, suppose that you were faced with two different option plays. Each of the two plays have the same Delta, and each option costs the same to purchase. But suppose one of the options carried a Gamma of 0.01, and the other carried a Gamma of 0.05. All other things being equal, the option contract with the higher Gamma would generally result in a greater profit for a given period of time, when compared to the option with a lower Gamma. A higher Gamma often equates to greater acceleration in profitability with a given increase in the value of the stock.