Gamma is one of the major ‘Greeks‘, ancient Greek letters that are used to signify key option trading metrics. An option’s gamma is the derivative of its delta, which itself is a measure of how quickly the option’s price changes relative to the price changes of the underlying security. Therefore, it is a measure of how an option’s rate of price changes as the strike price moves in and out of the money.
For example, an option with a high delta and a low gamma will experience a high and steady rate of price change alongside a change in the price of the underlying security, whereas an option with a high delta and a high gamma will experience an increasingly high rate of price change.
Gamma in Trading
Gamma is used in every day option trading as an indispensable extension of delta. Knowing the rate of change on an option’s price, its delta, without knowing the rate of change of the delta itself is only useful in a few rare situations where the trader is only interested in small price changes in the underlying security. In every other situation, it is an essential extension of its delta.
Traders use an option’s delta and gamma together to understand how the price will change as the option moves in and out of the money relative to the underlying security.
Due to the highly volatile nature of option prices, the Greeks are essential tools for all option traders. These metrics combined are one of the major metrics that are used by option traders to understand potential pricing behavior.
While by itself it is of little use without the accompanying delta metric, it is gamma that has the most significant impact on the price of an option through its impact on the option’s delta.