Understanding Gamma in Options Trading: Reactivity to Underlying Shifts and Strike Prices

Gamma movement

We have previously touched on the Gamma in terms of the change in the underlying. This is noted though the third order derivative known as ‘Speed’. To not rehash our earlier discussion, we will omit exploring ‘Speed’ here. It is worthwhile to comprehend Gamma’s behaviour when it comes to variances in the underlying, so that we can evade triggering transactions with high Gamma. Furthermore, there are other benefits of becoming familiarised with Gamma behaviour which we will discuss later on in this module. For now however, let us investigate how Gamma responds to shifts in the underlying.

Let us assume the spot price is 80; therefore, the strike of 80 is ATM. From our examination of the chart, we can see the following –

  1. This strike being set at 80 CE, it is deemed ATM when the spot price equalizes with it.
  2. Lower than 80 (including 65, 70 and 75) are ITM options and higher than 80 (including 85, 90 and 95) are OTM.
  3. The gamma value for OTM Options tends to be high, at 80 and above. This explains why the premium for these options fluctuates not significantly in absolute point terms, yet more substantially in % terms. For instance – the premium of an OTM option may go from Rs.2 to Rs.2.5, with an absolute shift of 50 paisa, but a % change of 25%.
  4. When the option reaches at-the-money status, gamma is at its highest, showing that ATM options are especially reactive to fluctuations in the underlying.
    1. It is advisable to refrain from shorting ATM options, since these have the highest Gamma.
  5. The gamma value of ITM options (80 and below) is relatively low, which means the delta of these options are less likely to change drastically with the underlying. However, they do possess a higher delta initially, meaning that though the rate of change of delta is small, the impact on the premium itself will be great.
  6. We can observe the same Gamma behaviour for other strikes such as 100 and 120. Demonstrating different strikes highlights that the Gamma behaves in an analogous manner for every option strike.

If you were overwhelmed by the discussion, here are 3 points you can take away from it:

  • The Delta value of the ATM option fluctuates quickly.
  • Both in the money (ITM) and out of the money (OTM) options experience gradual changes in their delta values.
  • It’s best to never purchase an ATM or ITM option expecting it to expire without value upon expiration.
  • OTM options are excellent short trade opportunities, especially if you plan to keep them until their expiry date with the expectation that it will become worthless.

 – Quick note on Greek interactions

To be a successful options trader, it is essential to comprehend how the individual option Greeks respond to different scenarios and how they interact with each other.

Up until now, we have only examined the adjustments in the option premium due to shifts in the spot rate. 

Changes are constantly occurring in the markets, with regard to these factors as well as the underlying price – so it is essential for an options trader to be mindful of how such fluctuations can sway the option premium.

Once you are familiar with the option Greeks, you will become aware of how they interact with each other. Gamma and time, gamma and volatility, volatility and time, delta and time – these are all examples of Greek cross interactions.

In the end, it is essential to consider a few factors when understanding the Greeks –

  1. What is the most advantageous strike to trade in this market circumstances?
  2. What do you anticipate the price of the strike will be – will it go up or down? Thus, would you choose to purchase or offload the option?
  3. If you’re considering purchasing an option, can the premium be expected to rise?
  4. Are you considering shorting an option? Can you evaluate potential risks that might be overlooked?

To gain full insight into the Greeks and how they interact with one another, it is essential to have answers to all questions.