Gamma is the most important greek, even though it's technically second order.
Why is that?
Let's talk about it.
I’ve written about Gamma before. I had a thread about gamma pinning, but let’s talk about why Gamma, in my opinion, is the most important greek for retail.
Let’s start by definition.Gamma is the change in delta per $1 move in the underlying. A $200 stock will have a lower gamma profile than a $10 stock, since the $200 stock gains delta /quicker/ than the $10 stock.
IE: a 5% move in the $200 stock is $10, a 5% move in the $10 stock is $.50.Now onto how gamma works.
Gamma increases into expiration date, a LEAP will have far less gamma than a weekly, hence why when people tell you to play earnings, they usually say to buy a month out. This is because the rate of change of gamma isn’t that high.This handy chart shows a brief primer on gamma vs time, which is also known as Color. I'll address color later.
As expiration nears, gamma increases since for ATM contracts, logically, the probability of OTM contracts being ITM decreases significantly, as does ITM becoming OTM. But why does gamma increase into expiration?
It’s all based on probability, and with the underlying moving towards a strike, the delta of that contract fluctuates between 0 and 1 at expiration. If the contract is ITM at expiration, the delta is 1, if not, it’s 0.It’s why 0dte’s are so popular. You guess the right direction, 1500% in a day isn’t out of reach.
Doesn’t that mean delta is the king greek? No, not necessarily. Since most retail traders trade on a 1-3 week timeframe with options (capital requirements, fat stacks, etc), gamma is your best friend and your greatest enemy.Back to this chart:
With the one month, you can see how fast gamma ramps as contracts would start to go ITM. This gamma ramp is your best friend as a retail trader. Buying contracts /just/ outside of this ramp for a speculative move in the underlying yields the highest potential of return.But how do I determine the ramp? Just look at the gamma on the chain. When you start seeing big skips, there’s the start of your gamma ramp. It typically lies about 1.5-2 standard deviations OTM/ITM.For example, on AMD, I have incredibly poorly drawn out the gamma ramp for the 3/11 expiration.
You can see how quickly it starts moving here. If I would (this is NFA) be bullish on AMD, I’d be targeting the 109C, as it has a 2 gamma jump with a $1 move in AMD. This would increase the delta on the contract from ~.12 -> ~.18, should it move upward.Now that we’ve covered the gamma ramp, what else is there? Is that all we need?
Yes, and no.
Let’s talk some strategies. If you’re bearish/bullish on the market, you would ideally be neutral gamma. You’re expecting big moves in either direction. What does that mean? For the case with AMD, you’d buy a straddle.This straddle, in accordance with this chart, would be a 109C/98P for identical gamma profile, giving you the theoretical best chance at gaining quickly with a sharp move. Being bullish on the market, you’d be long gamma, buying that 109C for the ramp. Short gamma would be long the 98P, since it has negative delta, by technicality.
What else is there to gamma? Well, the third order greeks are almost exclusively gamma related. Color: Gamma decay, this is the sensitivity of gamma due to time decay, effectively DGamma/DTheta. This doesn’t matter too much to retail traders. Most trading occurs within a 1-3 week window, it doesn’t have much effect aside from maybe $1 contract of decay, if that.Speed: Sensitivity of gamma to small changes in underlying price. I call this the gamma dance. When a $200 stock fluctuates between a dollar, gamma changes microscopically. We see gamma as .05, or whatever it is, but the gamma dance shows gamma at .057314. Zomma: Sensitivity of gamma to small changes in volatility (vega). This also has a form of a gamma dance. There isn’t anything special to this, since volatility adjusts slower than price. Moreso connected to longer dated contracts.Anyhow, that’s all I’ve got.
Let me know if you have any questions on twitter @falcon_fintwit.
Hope you learned something new today :)