How does Gamma affects risk in Options trading?
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- Updated On:13-Jul-2021
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Short Answer
Gamma is an Option Greek that affects the change in the Option premiums. Options traders need to know about Gamma and some other Option greeks to calculate the risk per trade. The effect of Gamma becomes stronger as the expiry approaches. The Gamma also increases as an Option becomes ITM or ATM from OTM. Know more about it here.
Detailed Answer
What is Gamma?
Gamma is an Options Greek that is responsible for the change in the premium of Options. Gamma defines the rate of change in Delta. In easier terms, Gamma affects the speed at which the Delta changes. As Delta is denoted by the change in Options in relation to the underlying. Similarly, Gamma signifies the rate of change in Delta
How does it work?
Let’s understand how Gamma works.
If the Delta is 0.5 of a particular option and if the underlying moves by 50 points then the option has to move by 25 points. Similarly, if the underlying moves by 100 points the Option has to increase or decrease by 50 points.
Now this will happen when the Option is OTM (Out of The Money) or ITM (In The Money). The Delta changes if the option goes from OTM to ATM. In an ATM (At The Money) option the Delta will not remain the same. If earlier it was at 0.5, The delta for an ATM option will increase to 0.6. This change in the delta depending on the Option price is called Gamma.
How it affects risk in Options Trading?
Gamma is not a constant factor. It keeps changing as per the underlying. The effect on Gamma is higher as the expiry closes in. Due to this Option selling might become riskier towards the expiry. A significant move in the underlying can lead to an increase in the option premiums drastically.
Let's take an example
The Put option of XYZ is sold at 10 rupees with a strike price of 90. It is currently trading at 100. The delta of the strike price is 0.5. Now if XYZ falls by 10 points the Put option premium should ideally go up by 5 points(10 x 0.5). But it will go up by 8 (10 x 0.8) points. This will lead the Put premiums to increase to 18 rupees. It happened because Gamma increases as and when the Option moves At The money. Due to this, the Delta of the option increased from 0.5 to 0.8.
Such moves can be bad for Option Sellers as the Option premiums might double or triple within no time. Any major news can have a massive impact on the prices of Options. This can cause enormous losses for option sellers. Although Option buyers might benefit from such moves if their direction is right. A premium of a far OTM option might increase exponentially if it comes to ATM. It’s because Gamma is higher as the option moves closer to ATM.
Conclusion
With this, you must have got an Idea of how Gamma works and the risks behind it. Gamma is technically not a harmful thing. It regulates the rate of change of Delta in an Option that ultimately changes the option price. The Gamma effect is stronger towards the expiry. Hence to prevent such things from affecting the position. You can square off your positions a couple of days before the expiry. This will ensure that any unusual moves in the market will not impact your position.
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