Gamma is a measure of the sensitivity of an option's price to changes in the underlying asset's volatility. You should use gamma when you want to:
1. Understand the Risk of Options
- High Gamma: Options with high gamma are very sensitive to volatility changes. This means that even small changes in volatility can lead to large price swings.
- Low Gamma: Options with low gamma are less sensitive to volatility changes. This means that price swings will be smaller, even with significant changes in volatility.
2. Profit from Volatility
- Volatility Expectations: If you expect volatility to increase, buying options with high gamma can be a good strategy. This is because the option's price will increase more rapidly than the underlying asset's price.
- Volatility Reduction: If you expect volatility to decrease, selling options with high gamma can be a good strategy. This is because the option's price will decrease more rapidly than the underlying asset's price.
3. Hedge Against Volatility
- Gamma Hedging: You can use options with high gamma to hedge against volatility. This is because the option's price will move in the opposite direction of the underlying asset's price when volatility changes.
Example:
Let's say you own a stock and are concerned about a potential drop in its price. You could buy call options on the stock to hedge against this risk. The call options will have a high gamma, meaning they will be sensitive to changes in volatility. If the stock price drops, the call options will lose value, but this loss will be offset by the gain in value from the stock.
4. Adjust Your Portfolio
- Gamma Neutral: You can adjust your portfolio to be gamma neutral by holding both long and short positions in options with high gamma. This will reduce your exposure to volatility.
Example:
You could buy a call option and sell a put option on the same underlying asset. This would create a gamma-neutral position, meaning that the overall gamma of your portfolio would be zero.
5. Trade Volatility
- Volatility Trading: You can trade options with high gamma to profit from changes in volatility. This is a more advanced strategy that requires a good understanding of how volatility affects option prices.
Example:
If you believe that volatility will increase, you could buy call options. If you believe that volatility will decrease, you could sell call options.
Remember: Gamma is a complex concept and there are many different factors to consider when using it. It is important to understand the risks involved before trading options with high gamma.
