Key Points

• A gamma neutral portfolio is an options position whose delta does not change even if the underlying security moves significantly.
• Gamma neutrality is achieved by adding additional options contracts to the portfolio, usually in contrast to current positions, a process known as gamma hedging.
• Delta-gamma hedging is typically used to lock in profits by creating a position that is both delta neutral and gamma neutral.

Understanding gamma neutrality

Directional risk in an options portfolio can be managed through delta hedging, thereby creating a delta-neutral or directionally ambiguous portfolio. The problem is that as the price of the underlying security changes, the delta of the option itself changes, meaning that a delta-neutral position can gain or lose delta, turning it into a directional speculation, especially if the underlying security moves significantly. Gamma Hedge attempts to neutralize this change in delta.

A gamma-neutral portfolio can be created by taking positions that offset gamma. This helps reduce volatility caused by changes in market prices and conditions. However, gamma-neutral portfolios are still subject to risk. For example, a position that was supposed to be neutral may actually become significantly risky if the assumptions used to build the portfolio prove to be wrong. Additionally, as prices change and time passes, positions need to be rebalanced.

Gamma-neutral options strategies can be used to establish positions in new securities or to adjust existing positions. The goal is to keep the overall gamma as close to zero as possible using a set of options. A value close to zero means that the delta value should not change when the price of the underlying security fluctuates.

It is important to note that if the goal is to achieve a durable delta-neutral strategy, delta-gamma hedging is typically employed. But a trader may also want to maintain a specific delta position, where the delta may be positive (or negative) but remain gamma neutral.

Locking in profits is a common use of gamma neutral positions. If a period of high volatility is expected and an options trading position is already making good profits, then rather than selling the position to lock in the profits and not make further gains, a delta neutral or gamma neutral hedge can be used to effectively lock in those profits.

Gamma neutral and delta neutral

A simple delta hedge can be created by purchasing a call option and simultaneously selling a certain amount of the underlying stock. If stock prices stay the same but volatility rises, traders may make profits unless the erosion of time value destroys those profits. Traders can add a short call option with a different strike price to the strategy to offset time value decay and protect against large delta swings. Adding a second call option to the position is a gamma hedge.

As the price of the underlying stock rises and falls, investors can buy or sell shares if they wish to keep their position neutral. This may increase trading volatility and costs. Delta and gamma hedging do not have to be completely neutral, traders can adjust the degree of positive or negative gamma they take on over time.

References

[1] TD Ameritrade. "Stock Options Greeks: Gamma Explained."

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