Gamma is a sensitivity measure of how Delta will change as the underlying price moves.
Most income traders pay attention to Delta (generally Delta neutral) and Vega (generally Vega negative). However Gamma is the hidden enemy, Theta‘s nemesis… But let’s first recap what Gamma is all about.
Gamma is Delta’s first derivative or in other words the Price’s second derivative.
- Options with positive Gamma will gain Delta as the underlying moves up
- Options with positive Gamma will lose Delta as the underlying goes down
- Options with negative Gamma will gain Delta as the underlying goes down
- Options with negative Gamma will lose Delta as the underlying moves up
- Long Options = Long Gamma
- Short Options = Short Gamma
Gamma is a by-product of Theta: one cannot have positive Gamma and positive Theta at the same time. As income traders, we are net sellers of put and call options i.e. we construct Theta positive strategies, hence also Gamma negative strategies.
When constructing a put or call spread, Gamma is eliminated halfway i.e. in the middle of the spread and goes negative on the short side where money is to be made, and positive where money is to be lost… Income traders do not like Gamma!
As shown on the TOS screenshot on the right, ATM options will have the most gamma, conversely ITM and OTM options will have less gamma i.e. the further they are from ATM the less gamma they will have.
Also, when trading horizontal spreads, front month options have the most Gamma, conversely back month options will have less Gamma.
The longer the option has until expiration, the less Gamma it will have. In other words, Gamma increases with time, particularly near expiration. Gamma and Theta move in opposite direction… For that reason, OM strategies are always closed at least 7 DTE (1 week prior to expiration), to avoid running into Gamma issues that are sometimes very difficult to tackle.
More info on Gamma here.