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Gamma hedging is a trading strategy designed to keep the delta of an options position stable, usually delta neutral, as the price of the underlying asset changes.
Gamma hedging is a trading strategy designed to keep the delta of an options position stable, usually delta neutral, as the price of the underlying asset changes. This strategy is used to reduce the risk associated with a sharp rise or fall in the underlying security, especially in the final days approaching expiration.
The gamma of an option position is the rate at which the option's delta changes for every 1-point change in the underlying asset's price. Gamma is an important measure of the relative convexity of a derivative's value relative to the underlying asset. In contrast, delta hedging strategies can only reduce the impact of small fluctuations in the underlying asset price on option prices.
A gamma neutral option position is one that has been protected from large movements in the underlying security. Achieving a gamma-neutral position is a method of managing risk in options trading by building a portfolio of assets with a rate of delta change close to zero, even if the underlying asset moves up or down. This process is called gamma hedging. The gamma-neutral portfolio thus hedges against second-order time price sensitivity.
Gamma hedging works by adding additional options contracts to the portfolio, usually against the current position. For example, if a position holds a large number of calls, a trader might add a small number of puts to offset an unexpected drop in price over the next 24 to 48 hours, or sell carefully selected calls at different strike prices. Gamma hedging is a complex activity that requires careful calculation to be implemented correctly.
Gamma is a standard variable name inspired by the Greek letters and derived from the Black-Scholes model, the first formula recognized as the standard for option pricing. In this formula, there are two variables that help traders understand how the option price changes as the price of the underlying security changes: delta and gamma.
Delta tells traders how much the option price is expected to change due to a small change (specifically, a $1 change) in the underlying stock or asset.
Gamma refers to the rate of change of option delta as the price of the underlying stock or other asset changes. Essentially, gamma is the rate of change of an option's price. However, some traders also view gamma as the change in expectations resulting from two consecutive 2 changes.
Delta-gamma hedging is an options strategy that combines delta and gamma hedging to mitigate the risk of changes in the underlying asset and its own delta. A separate delta hedge protects a position from small changes in the underlying asset. However, larger changes can alter the hedge (change the delta), leaving the position exposed. By adding gamma hedging, delta hedging is kept intact.
When implementing delta-gamma hedging, investors need to create new hedges when the underlying asset's delta changes. Depending on whether the price of the underlying asset rises or falls and the magnitude of the change, the number of underlying shares bought or sold will vary.
Traders trying to maintain delta-hedged or delta-neutral positions typically place trades that offer little change to smaller short-term price movements. This type of trade is typically a bet that volatility, or that demand for options on that security will rise or fall significantly in the future. However, even delta hedging does not effectively protect options traders the day before expiration. On this day, even normal fluctuations in the price of the underlying security can cause significant changes in the option price as there is little time left before expiration. Therefore, delta hedging is not enough in this case.
Gamma hedging complements the delta hedging strategy and is designed to protect traders from larger than expected price changes, or rather, protect the entire portfolio, especially when time value has almost completely disappeared, protecting options from rapid price changes.
Important Note: While traders in many cases will seek delta-gamma hedging to remain delta neutral; conversely, traders may also wish to maintain a specific delta position, which may be positive delta (or negative delta), but while remaining gamma neutral.
As shown above, delta hedging and gamma hedging are often used in combination. A simple delta hedge can be created by simultaneously purchasing a call option and shorting a certain amount of the underlying stock. If a stock's price remains the same but volatility rises, traders can make a profit unless time value erosion destroys those profits. Traders can offset the time value impairment and protect their exposure to large moves in delta by adding a put option with a different strike price to these strategies; adding this second call option to the position creates a gamma hedge.
As the underlying stock rises and falls in value, investors can buy or sell shares as needed to keep the 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 are exposed to over time.
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