How Options Gamma Works

  • August 22, 2018

Watch our video on how options gamma affects options contracts.

What is Options Gamma and How Is It Calculated?

  • Options gamma measures the rate of change of the delta. Delta tells you how much an options price changes given a $1 movement in a stock's price. If a security is $100, strike is $100, delta is 40, gamma is 2 and price goes up to $101 then the delta moves up to 42.

O.G. is a member of the Greeks family in options trading. Gamma is one of the more ambiguous Greeks but is still important in analyzing different strategies. Learn about its importance when options trading in the video above. 

Options trading strategies have many moving parts which can affect profit as well as loss. However, trading options is less expensive than trading shares. One options contract controls 100 shares but you're paying a premium instead of the price per share.

That, in fact, makes it cheaper than buying 100 shares of a stock. However, options are more risky because of the many factors that affect different options (read our stock market basics page).

1. Basics of Options Gamma

Delta increases and decreases with a stock's price; whereas gamma is the constant that measures that rate of change.

Stock options give you the right but not the obligation to buy or sell a stock at a specific price. Calls and puts are the bullish and bearish components. 

The great thing about put options is that they're like shorting but all brokers have options whereas not every broker has shares to short. Read our post on what does shorting a stock mean if you need to learn more.

Options are a great tool that allows you to make money in any market. There are strategies for when a stock is moving up, down and even sideways. However, since they tend to be risky, it's imperative to study and practice.

A stock may look attractive to you but can have a high gamma. An option with a higher gamma is a much riskier option. However, a contract with a lower gamma is less risky.

A higher gamma means the stock is much more volatile which can actually be a good thing. However, if you're a trader that like more predictable trades, then you'd want to stay away from a contract with a high gamma.

A high gamma means that any stock that has an unfavorable swing will have a bigger negative impact. In essence, with high gamma expect volatile moves. If you're day trading options for income this can be good as long as you choose the correct direction.
options gamma

2. Using to Form Strategies

While it may one of the more obscure Greeks it can be used to to form your trading strategy. Just think of gamma as a way to measure the stability of an option.

Delta represents to probability of an option ending up in the money. It is representative of the stability of that probability happening over time.

Delta and gamma tend to work hand in hand. Options expire. As a result, you want to be able to turn a profit before they do. However, 80% of options end up expiring worthless.That's a lot of lost money.

The reason for that could be that people treat options like shares when they're not. There's the Greeks, open interest, extrinsic value and time decay that affect how a contract profits or loses.

While that may seem overwhelming, don't let it deter you from learning options. You can customize your options chain to show the different parts that you're focused on.

Remember that gamma brings about a higher risk level. However, that's not a bad thing especially if you've given yourself enough time. For every $1 a stock moves, gamma accelerates profit in your favor.

Gamma also decelerates loss for every $1 that price moves against you. In other words, for every $1 the trade you're in moves, you're getting a nice return on the capital you put up. Take our options trading course.

3. How Direction Matters With Options Gamma

Just like trading shares, direction and patterns matter when trading options. One could argue even more so because of the affecting measures in options.

One of the really great things about options is the fact that you can get a much larger return on your investment with options than shares. The reason for that is the different factors that affect profit. However, those same factors can take your profit and turn it into loss and quickly. This is why paper trading options is so important to do.

If you know patterns and candlesticks, then you have a much better chance at making a good trade. However, even the best traders fail 30-40% of the time.

Trades will go against you even if you had the best setup. It's important to have proper risk management. It's ok to close out a losing trade and take a loss. Especially with options.

Many times the reason options expire worthless is because traders hold them, hoping they'll recover. They either didn't give themselves enough time or they bought the wrong option.

Hence the importance of knowing what direction the stock is heading. Have you taken a look at our trading service yet? We teach candlesticks patterns and candlestick reversals on a daily basis in our trade rooms.

What Does It Mean to Be Long Gamma?

  1. Here's what it means to be long gamma:
  2. Being long the option means that you want a higher gamma.
  3. The delta of your security will increase based on gamma of position.
  4. Example: delta = $0.50 then contract moves up or down this amount per $1.
options gamma

Bottom Line on Options Gamma

Options Gamma tells us how fast delta changes when a stock moves. It's most helpful using it to see the stability of an option's probability for reaching the strike price before it expires. Since options trading has so much that goes into it, take the time to study and practice. 

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