Those are:
- Delta
- Theta
- Vega
- Gamma
Today, we’re talking about gamma, which is often described as the “delta of delta.” We know that delta measures an option’s sensitivity to price changes in the underlying – a $1.00 move in the underlying results in a $0.30 move in a chance with a delta of 0.30. Simple enough.
Gamma works similarly. Gamma measures the delta’s sensitivity to a price change in the underlying. An option with a delta of 0.30 and gamma of 0.03 would have a delta of 0.33 following a $1.00 move in the underlying.
The Importance of Gamma
Without proper context, gamma might seem like an exciting metric like those hyper-specific statistics announcers love citing when you’re watching football. This quarterback throws interceptions twice as often when targeting defensive backs whose last name starts with a ‘B.’ Interesting, but does that mean anything?
The gamma of an options position has substantial implications for how the P & L will play out over the life of the position. Positions with positive gamma have very different characteristics than those with negative traits.
To provide a bit of context, Goldman Sachs said this about gamma:
Gamma – the potential delta-hedging of options positions – is one of the more prominent sources of non-fundamental economic activity in global markets. Market makers who delta-hedge their option positions are economically driven to trade substantial amounts of underlying shares or futures strictly as a result of the price of the underlying itself changing, not as a result of fundamental news and without regard to the liquidity available. As a result, gamma can cause markets to overreact to essential news (“short gamma”) or under-react to crucial information (“long gamma”).
Sometimes gamma can play a huge role in an options position, and other times it’s a relative non-factor. Understanding gamma and how it interplays with the other Greeks is vital to knowing when your P&L is driven by gamma.
Just like delta, you can have a positive or negative gamma position. A favorable gamma position is often referred to as “long gamma,” as negative gamma is “short gamma.”
What is a Long Gamma Options Position?
A trader is a long gamma when his options position has positive gamma. This involves being net-long options.
Most non-professional options traders live in the positive gamma arena. Positions like outright long calls or puts and vertical debit spreads are typical examples of long gamma trades.
As a rule of thumb, long gamma positions are frequently short theta, meaning they suffer from the negative carry of theta decay.
As a result, long gamma positions benefit significantly from strong trending markets, whereas you’ll see a slow withering of your P&L in a sideways, range-bound market due to theta decay.
Unlike short gamma positions, your total exposure in a long gamma position increases when you’re right on the trade. If you’re long a call (a favorable gamma position), your deltas will increase as you’re correct on the trade.
This component of long gamma positions makes them far easier to manage than short gamma positions. It’s psychologically easy to work positions when your exposure only grows if you’re making money already. So long as you size your positions correctly, you don’t have to worry about positions getting out of control. And when you’re right, you get paid big time.
Short Gamma
Suppose you’ve been around online options trading discussions like Twitter and Reddit in the last few years. In that case, you’re probably already familiar with short gamma positioning, which is responsible for the almighty ‘gamma squeeze.’
A short gamma is a net-short option that carries all of the benefits and drawbacks of selling options.
Namely:
- Benefits from low volatility and sideways price action
- Exposure grows in the wrong direction (your position gets more prominent when you’re wrong)
- Generally concave payoff profiles (limited gain for potentially more considerable loss)
- Vulnerable to “gamma squeezes.”
- Benefits from theta decay
What is a Gamma Squeeze?
A gamma squeeze is an entirely separate subject from identifying the pros and cons of the gamma level in your options positions, but explaining it can illustrate the power of gamma.
A gamma squeeze occurs when too many traders, mostly market makers, get caught in a short gamma position when volatility suddenly comes into a market. Market makers are forced to quickly adjust their delta hedges which further fuels the rally, creating a feedback loop.
Essentially, options traders deduced two things about option market makers:
- They’re frequently short gamma
- They systematically delta hedge
The logical follow-up here is that if a rapid price move occurs while market makers are very short gamma, their hedging response will create a feedback loop, continually pushing the price in the trend’s direction.
Here’s how that theoretically works.
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Market makers are generally short gamma and short options because customers tend to be long options for hedging and speculation purposes.
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This gets exaggerated in stocks loved by retail traders who love OTM calls, which have high gamma, forcing market makers to get very short gamma.
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So you already have a hot pot, and a catalyst comes into the market, creating a frenzy of call buying.
- The quick price moves in the underlying forces market makers to adjust their delta hedges, which fuels the rally even further, creating a feedback loop.
Final Thoughts
The example of a gamma squeeze, even if they might be a bit overhyped nowadays, perfectly illustrates the importance of understanding gamma in options trading. It’s a real-life example showing the power of gamma and the type of market moves it can fuel.
Related articles
- Options Trading Greeks: Gamma For Speed
- Why You Should Not Ignore Negative Gamma
- Estimating Gamma For Calls Or Puts
- What Is Gamma Hedging And Why Is Everyone Talking About It?
- Market Neutral Strategies: Long Or Short Gamma?
Original source: https://steadyoptions.com/articles/short-gamma-vs-long-gamma-r730/