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Why should I care about a Delta and Gamma when evaluating a particular option?

Why should I care about a Delta and Gamma when evaluating a particular option?
Answer for: Why should I care about a Delta and Gamma when evaluating a particular option?
Justin Freeman time-icon2 months ago

Delta and Gamma are measures relating to the change in price of an option.

Delta

Delta measures how much the price of an option changes when the price of the underlier changes. If the price of the underlier changes by +1 point and the Call option changes in price by +1 point, then the Delta of the Call option is 1.0.  Puts being short positions have an inverse relationship, so in the above example a Delta of -1.0 would be associated with a Put that decreases in price by -1 when the underlier increases by 1.0.

Gamma

Gamma is the rate at which Delta itself changes over time. Take for example a deep in the money Call option with relatively low volatility and two weeks until expiry date. This option will closely mirror the price of the underlier as you are effectively holding a long position in the underlier and according to the volatility data unlikely to be shaken out of the position by price movement between now and expiry date. Gamma will be low as Delta is not changing considerably. The only likely change to Delta is that it will incrementally increase to be even closer to 1.0 as the expiry date nears and the option trades even more and more in line with the underlier that it will soon become.

If the above example considered a Call option which is a long way out of the money, you’d see it has a low Delta as price moves in the underlier have little impact on the option because of the perception that the price will not move enough to make them significant. As with the in the money scenario it will have low Gamma as changes to Delta are minimal and edge closer to zero as expiry date nears.

Trading Strategies

Considering Delta, Gamma and time and what they are ‘saying to you’ can give you an insight into market behavior but are also used for various types of trading strategies. It’s an interesting and sometimes complex subject and only recommended for the most experienced of traders.

An example is a portfolio manager at a Hedge Fund who has turned in a good year’s performance and is watching the markets in the first week of December. She’s already looking at taking home a healthy bonus, but even fantastic trading results during the last few weeks of December are unlikely to be converted into extra remuneration as bonuses have already been discussed and are unlikely to change dramatically. At this point there is personal advantage to be gained by buying out of the money Put / Call options with expiry dates a long way into the following year. Premiums will be paid from this year’s P&L and any profits taken next year. The trades are long odds, but costs are minimized to the amounts of premium paid.

If volatility picks up in the coming year the underlier might move closer to one of the strike prices. Delta and Gamma would increase in value as will the price of the long option position. Even if the option’s strike price is not achieved, moving towards it to an extent that it is no longer considered out of the money will be reflected with the price of the option increasing and profit for the trading account. During this move from ‘out of the money’ towards ‘in the money’, Gamma will increase in value reflecting the ever changing Delta.

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