What is Gamma Hedging?
Gamma hedging is a trading method that maintains a constant delta in an options position, frequently remaining neutral when the underlying asset changes price. It reduces risk when the underlying security makes significant up-or-down swings, especially in the last days before expiration.
The gamma of an option position is the delta change per 1-point change in the underlying asset’s price. Gamma measures the convexity of a derivative’s value relative to the underlying asset. In contrast, a delta hedging technique mitigates the impact of minor underlying price fluctuations on option prices.
How Gamma Hedging Works
Gamma-neutral options shield against substantial changes in an underlying security. A gamma-neutral position in options trading involves creating an asset portfolio with a delta close to zero, regardless of the underlying movement. She is referred to as gamma hedging. A gamma-neutral portfolio protects against second-order time price sensitivity.
Gamma hedging involves adding option contracts to a portfolio, generally against the present position. Suppose a trader had a lot of calls. In that case, they may add a minor put-option position to balance an unexpected price decline in 24 to 48 hours or sell a carefully determined quantity of call options at a different strike price. The gamma hedging demands precise computation.
Gamma vs. Delta
Gamma, a reference to the Greek alphabet, is a typical variable in the Black-Scholes Model, the first formula for pricing options. Delta and gamma help traders comprehend how option prices vary with underlying securities prices in this calculation.
Delta informs traders of the predicted price change of an option based on a one-dollar change in the underlying stock or asset.
Gamma measures an option’s delta’s relationship to a stock or other asset’s price movement. Gamma refers to the pace of price fluctuation for an option. Some traders see gamma as the projected change from the second successive one-dollar price movement. Thus, adding gamma and delta to delta yields the predicted change from a two-dollar security move.
Delta-Gamma Hedging
Delta-gamma hedging is an options technique that uses delta and gamma hedges to reduce the risk of changes in the underlying asset and delta as it moves. Delta hedging protects positions from minor fluctuations in the underlying asset. Significant changes to the hedge (delta) leave the position susceptible. Add a gamma hedge to preserve the delta hedge.
To use a gamma hedge with a delta hedge, investors must generate fresh hedges as the asset’s delta changes. Delta-gamma hedges buy or sell underlying shares according to whether the asset price is rising or falling and by how much.
A delta-hedged or delta-neutral trader typically makes tiny changes depending on short-term price fluctuations. A trade involves betting on the volatility of a security or the demand for its options to rise or fall significantly in the future. Delta hedging won’t guarantee options traders’ safety on expiry day. On this day, with such little time before expiration, even regular price volatility in the underlying asset might produce large option price fluctuations. In these instances, delta hedging is insufficient.
Gamma hedging is used in a delta-hedged strategy to protect traders against changes to an asset or portfolio that are bigger than expected. This is usually done to protect traders from fast price changes in options when the time value has almost entirely been lost.
Many traders desire a delta-gamma hedge that is neutral, but some prefer to keep a delta position that is positive or negative while remaining neutral.
Gamma vs. Delta Hedging
As mentioned above, delta- and gamma-hedging are commonly associated. To build a delta hedge, trade call options and short a specific number of shares of the underlying company simultaneously. If the stock price stays the same but volatility grows, the trader may benefit until time value erosion wipes them off. Trading strategies may include a gamma hedge, which involves adding a short call with a different strike price to balance temporal value decay and guard against big delta moves.
Investors can purchase or sell the underlying stock to stay neutral as its value fluctuates. It can raise trading volatility and expenses. Traders can modify their exposure to positive or negative gamma over time, as delta and gamma hedging need not be neutral.
Conclusion
- Gamma hedging is a complex option technique that reduces option position exposure to significant securities movements.
- At option expiration, gamma hedging protects against sudden price movements in the underlying asset.
- Delta hedging typically includes gamma hedging.
