You should know by now that there are several factors that affect price when trading options – not just the price movement of the underlying asset.
The variables that exist that account for the fluctuations of an option’s price movement are known as the options “Greeks,” and we’ve covered many of these – theta, a measurement of options time decay; delta, how an option’s price will move with price movements in the underlying; and vega, how sensitive an option is to the implied volatility associated with the underlying.
I’ve told you that delta is the single most important factor in determining an option’s price. Today’s Greek shares a special relationship with the delta, measuring the rate of change in the most important component in an option’s price.
I like to call it the “delta accelerator.”
Here’s what I’m talking about…
How Gamma Works
Gamma is the options Greek that shows how much the delta will change with a $1.00 movement in the underlying security.
Where delta shows how much an option price will increase with the next $1.00 move in a stock, gamma measures how fast the delta of that option price will increase after that $1.00 move in the stock.
Let’s take a look at a hypothetical situation…
Say you are looking at a stock trading at $45.20. You expect the stock to move higher, so you target a $45 call option. The $45 call is priced at $2.00, with a delta of 0.52 and a gamma of .05.
Here is how things theoretically would work on a $1.00 upward move on the stock…
The stock goes up to $46.20. On delta alone, the option will go up to $2.52 (option at $2.00 + delta of 0.52 = $2.52).
When the stock goes up another $1.00 to $47.20, the delta now becomes 0.57. That increase is represented by the gamma of 0.05 (0.52 + 0.05 = 0.57). The stock should then go higher by this $0.57.
When the stock goes up another dollar to $48.20, what happens to the delta? If you added 0.05 to the delta of 0.57, you should come up with 0.62 (0.57 current delta + gamma of .05 = 0.62).
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