Gamma Explained: What is it & How to Trade it

[Music] hey everyone and welcome back to mike and his whiteboard my name is mike this is my whiteboard and today we're going to talk about gamma now if you're new to this show this is a show where we construct concepts visually for you so last week we got into the greeks so what the greeks are you'll see them on all the platforms think or swim doe they're basically variables that you can use to get a better sense of different things about your portfolio so last week we got into delta which is the rate of change of an options price and we basically learned how we can use that to hedge our positions see what our potential probability of being in the money is etc so today we're going to look at gamma and the reason i talk about delta before gamma is because gamma is essentially a derivative of delta so if delta is the rate of change of an options price that's a derivative of the options price we've got delta and gamma is a derivative of delta so basically what gamma is is the rate of change of delta so it's great to know and learn all these different greeks because it once you learn them and understand how they work it gives you a better sense of how different market aspects are going to change your option position so without further ado let's get into gamma so again gamma is the rate of change of delta so what we're going to do here is take a look at an example of a trade we've got a 75 stock price that's at the money so we're going to look at an increase and a decrease and see what happens to the option price the gamma and basically the stock price and and what all how all these things kind of coagulate together so right now we're looking at a 45 day till expiration call so if i've got a stock price at 75 and the option price is at 290 and i know that the delta is the rate of change of the options price if we go from 75 to 76 my option price should theoretically increase by 50 cents which you can see here so the option price increased from 290 to 340 given a one dollar increase in that stock price so we can see here that the delta has changed from 50 to 55 and that's because we had a gamma of 5 cents so this is how everything kind of works together so again we've got our stock price at 75 we're looking at an at the money call so if i were to purchase that call for example and the stock price goes up to 76 if that call was worth 290 and had a 50 delta which is what you'll see with at the money options they're most likely going to have a 50 delta because you're going to have a 50 chance of being in the money and as we learned last week a delta is essentially equivalent to the probability of being in the money so we've got this rate of change here which you can clearly see in the option price increase and now you can see that our delta goes from 50 to 55 and that's because we have a gamma of 0.05 so what does this tell us so basically what this tells us when we have longer days till expiration trades is that our gamma risk is low so what you'll hear on the dough if you're looking at the follow page people might refer to something as having a low or high gamma risk so what we like to do is avoid gamma risk altogether because basically what gamma risk is is the rate of change of delta and if that rate of change of delta is very high it can basically swing my option price down or up and that's not something i want to do if i'm trying to be mechanical and stay in a high probability environment because if i if my option price is swinging up and down it's going to have a lot of variance and i might be a loser one second and a winner the next second so that's not something i'm really interested in if i'm looking to get high probability trades over longevity rather than direction so let's see what happens when we go down one strike so basically if i if i buy a call and the stock price goes down and that call option had a 50 delta or a 45 delta i should say then my option price should decrease 45 cents which you see here and that's because when you're training from delta although the gamma is going to change it's going to increase and decrease with that stock price movement so you can see that the stock the option price decreased 45 cents because we're looking at the delta here of 45 cents so again well the real takeaway here is that when we're looking at 45 data expiration trades or trades that are not in expiration week so expiration week is known to have high gamma risk you can see that regardless of whether the stock price moves up or down the option price doesn't sway too drastically so now we're going to compare this to a much closer to expiration trade and we're going to look at a two day till expiration call spread so if we look at the next slide here we can see that we've got the same information so we're going to just keep it consistent we've got the 75 stock price we're going to look up and down one strike and we're going to see how our option prices are affected now given an increase in gamma because again the closer you get to expiration the higher gamma is going to be and that's where that gamma risk comes into play so we've got a 75 stock price and now we're looking at an option price of 65 cents so the option price is worth a lot less because we only have two days till expiration so regardless of where i am except for in the money options it's going to be a lot less because there's a lot less extrinsic value which we learned about in a previous whiteboard so extrinsic value is made up of time and volatility and they kind of combine together so the less time that there is for a stock to be volatile the less value there's going to be in that extrinsic value so now we're looking at a gamma of 0.25 so now we've got the option price at 65 cents we still have the same delta of 50. so you can see that if the stock price goes up one dollar now my option price almost doubles so we've got this big swing going up one stock one uh one point here in the stock price and now you see that the gamma is much higher so it's five times the value of our previous example so now my delta changes from 50 to 75 as opposed to 50 to 55. so this is just going to go higher and higher so if i was looking at an option price now of 115 and now i've got a delta 0.75 now if there's another increase it's going to increase another 75 cents which is almost 100 percent of that value so that's where the gamma risk comes into play so a two point move can drastically change this option price so you would see if this was 75 cents and a dollar fifteen so that would be a dollar ninety so this option price has now pretty much tripled with a two point move in the stock price so if i sold this call here instead of buying it then i might be at a loser already with just a two point move and that can happen at any time because you know stocks go up and down there's a lot of random variance in that intraday movement so that's why we like to avoid this gamma risk here so let's look at what happens when we go down so if we're going from 75 to 74 if i bought this call at 75 and it was worth 65 cents if i have a delta of 50 and we're going down to 25 cents now this is going to decrease 25 cents here so basically i've lost 50 of my value in just one stock point move so again you can see that gamma being high is not really good if i want to hold that delta or hold that option price because when we're looking at a high gamma we're looking at a high rate of change of delta which means that when you're looking at a bell curve so we're going to look at this on the next slide here so if we want to throw this up this would be a great time to talk about it so when you're looking at a longer term data expiration bell curve you're basically going to have a wide range of strikes and the bell curve of probabilities is going to be pretty wide across those strikes so as you can see here we're looking at a 45 day till expiration called delta curve and if we're looking at the 75 stock price and we're looking at just the call side so we're looking below the stock price so what happens when the stock price goes from 75 to 74. you can see that the delta pretty much holds its value so the delta doesn't change too much so what you're going to see in relation to that option price is if you're going from 75 to 74 to 73 since the delta is holding its value you'll see pretty much a stair step decrease in the option price now if we compare that to the shorter term diesel expiration so we've got the two digital expiration here you can see that since there's less time for the stock to be volatile our basically our standard deviation curve goes from this to something much smaller that's wrapped around the stock price so what you see here is the reduction in the price from 75 to 74 basically reduces the delta much more drastically so you can clearly see that this has a much higher gamma than the blue line above it so if we're going from 75 to 74 to 73 now instead of a steady stair step decrease in the option price we've got kind of a drastic slope down so regardless of whether i'm buying an option or selling an option let's say i sell an option at 74 and the stock price goes to 75 now of course i sold it here but now it's worth this much so i'm going to be seeing a loss right away whereas if i sold an option at 45's diesel expiration at 74 and then it went to 75 you can see that my increase in the option price isn't too drastic and i can pretty much hold that value and i still have plenty of time to be right so it's a much better situation in our eyes so let's get some takeaways here for gamma so the very first one is gamma is the rate of change of an options delta so again if i've got an option price and i know that delta is the rate of change of that option price and gamma is the rate of change of that delta now you can see how they kind of interact so they're all tied together and that's what you're going to see once we start learning more about all these greeks we're going to look at theta tomorrow and we're going to get into some others in the future but you can see that they're all going to be tied together and that's what kind of creates this matrix of option price movement the next one is gamma risk grows as expiration nears and that's because like we were showing before when i'm looking at 45 days till expiration i've got a standard deviation curve that's pretty wide and that gives me a better range to be correct and it's going to have a lower gamma risk because the deltas hold their value from a one point move to a one point move whereas when i reduce the dasal expiration that bell curve gets really narrow so when i'm going from those one point moves to the other one point move you'll basically see a greater gamma or a greater change in delta which is something that we like to stay away from so what we can do when we're trading to stay away from that is if i'm getting to expiration week and i know that gamma is going to be increasing i can roll my trade into the future which basically reverts my two days till expiration chart back to the 45 day which we're comfortable with and last but not least gamma can be thought of as the stability or instability of an option's probability so we know that delta can be thought of as the probability of being in the money so if i know that gamma is the rate of change of delta if i've got low gamma risk then that would give me a pretty stable delta so if i'm looking at a 45-day total expiration trade and the stock's going up and down a point it really shouldn't affect my option price too much where on the other hand if i'm looking at an instability of an options price i'm going to know that that's going to have a high gamma value and that's because since gamma is the rate of change of delta if i'm looking at an unstable option price given a one dollar increase or decrease in that option or the stock i should say then i know that i'm in a high gamma risk environment which is what we like to avoid so again we would roll into the future in that scenario to avoid it all together now this has been gamma if you've got any questions at all send me an email at support or at dough.com or support and we are actually going to have a blog post on this so we're going to be releasing a blog post in the next few days so if you go to dough.com blog it's a great source of written content there written information if you need anything else on that site we've got plenty of different strategies as well but you can also tweet us at doughtrading do trader mike so tomorrow we're going to continue with our greek discussion we're going to talk about theta and basically how that affects an option price and then we're going to step away from that and get into a little strategy on thursday and the beginning of next week but we will come back to discuss vega and beta as well because those are pretty much the five greeks that we like to look at here thanks so much for tuning in until tomorrow my name is mike and this has been mike and his whiteboard what up everybody i hope you like this video click below to watch more videos subscribe to our channel and don't forget to check out tom [Music] [Applause] [Music]

Channel: tastylive

Views: 149,604

Keywords: gamma options trading, options trading, gamma, option greeks, options, stock market, options trading for beginners, how to trade options, option greeks explained, option gamma explained, stock options, options strategies, options greeks, options gamma, delta, options for beginners, tastytrade

Id: t2ty3MuQ68Q

Length: 13min 54sec (834 seconds)

Published: Tue Feb 02 2016