The Gamma Trade in Options
Gamma confuses some options traders because it's a “secondary” indicator. It measures the speed of change in another indicator: delta.
Delta measures the rate of premium change in the options related to changes in the underlying (and of course is affected by time and proximity). Gamma measures how quickly delta moves. It tracks delta and reflects changing volatility, so looking at delta and gamma together is a great way to compare volatility between two or more issues.
Delta is measured with a single “outcome” value. So delta of 1.0 tells you that the option is moving exactly the same degree as the underlying. If delta is 0.75 it means that the option changes 75 cents for every point of movement in the underlying.
In comparison, gamma tells you how responsive delta is, meaning how quickly it changes. This quantifies the tendency in the options market for options pricing to lag behind stock price movement. The faster the reaction of option premium to the underlying movement, the higher its volatility - that is gamma in a nutshell.
Knowing the approximate gamma level helps you to judge market risk, by placing a simple value on volatility. You see this based on proximity and time. The closer to At The Money ("ATM") an option becomes, the more likely you are to see gamma increase; and as the option moves farther In The Money ("ITM") or On The Money ("OTM"), the lower gamma is likely to be.
Options traders are always wishing for the perfect “cause and effect” in premium changes versus underlying price movement. But this is not a reliable ideal, and it is rarely achieved.
Options pricing is unpredictable (as if one didn't know that already), but the point is that unpredictability is why you need both delta and gamma. With gamma, you are better equipped to view delta changes in view of proximity of strike to underlying price, and to watch it evolve as expiration approaches. This is a reliable way to estimate the volatility factor in overall value, and of seeing how IV works with different underlying securities.
Rather than trying to calculate delta or gamma, why not rely on a free online calculator? The CBOE provides a free calculator that provides you with all of the Greeks. For example Linn Energy, LLC (NASDAQ: LINE) is a midcap in the energy market. For the calculator, go to CBOE.com and click on the link for “tools” and then on “options calculator.”
At the close of June 11, LINE was valued at $36.15. The calculator revealed gamma of the July 36 strike at 0/1981 for the call and at 0.1990 for the put. It makes more sense when you also track delta, and a moment in time may not be as revealing as trend analysis. CBOE is a great place to start.
The analysis of gamma is one means for tracking volatility. Entry and exit timing demands skill in this, and it is never easy on your own. To improve your option trade timing, check the Benzinga service Options & Volatility Edge which is designed to help you improve selection of options as well as timing of your trades.
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