Here is the next part of the options trading playbook. We have discussed the meaning of option greeks and the first option greeks in our earlier blog. Continuing with the series, we will discuss the next level of option greeks, the ‘Gamma Greek’. Read on to learn more about this term and its importance in options trading.
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To calculate Gamma, it is crucial to understand the concept of Delta first. Delta measures how much an option's value changes with respect to the underlying asset's price. Gamma, on the other hand, measures how fast the Delta itself changes.
The formula to calculate Gamma is as follows:
Gamma = (?Delta) / (?Underlying Asset Price)
Here's an example to illustrate the calculation of Gamma for an option:
Let's assume a trader has purchased a call option on a stock. The option has the following details -
Option Price (V) - Rs. 10.00
Underlying Stock Price (S) - Rs. 100.00
Delta (?): 0.5
Now, let's consider two scenarios where the stock price changes:
Scenario 1: The stock price increases by Rs. 1.00 to Rs. 101.00.
Scenario 2: The stock price increases further by Rs. 1.00 to ?102.00.
To calculate Gamma, you need to determine the change in Delta (??) for a given change in the underlying stock price (?Underlying Asset Price).
Calculate the Delta value for the first scenario:
Delta 1 = ?V1 / ?S1 = (New Option Price - Option Price) / (New Stock Price - Stock Price)
Delta 1 = (?V1) / (?S1) = (Rs. 10.50 - Rs. 10.00) / (Rs. 101.00 - Rs. 100.00)
Delta 1 = Rs. 0.50 / Rs. 1.00 = 0.50
Calculate the Delta value for the second scenario:
Delta 2 = ?V2 / ?S2 = (New Option Price - Option Price) / (New Stock Price - Stock Price)
Delta 2 = (?V2) / (?S2) = (Rs. 11.00 - Rs. 10.50) / (Rs. 102.00 - Rs. 101.00)
Delta 2 = Rs. 0.50 / Rs. 1.00 = 0.50
Now, calculate the change in Delta (?Delta) by subtracting Delta 2 from Delta 1:
?Delta = Delta 1 - Delta 2 = 0.50 - 0.50 = 0.00
Finally, calculate Gamma using the formula mentioned earlier:
Gamma = (?Delta) / (?Underlying Asset Price)
Gamma = 0.00 / Rs. 1.00 = 0.00
In this example, the calculated Gamma is zero. This implies that Delta does not change significantly with small movements in the stock price. It indicates that the option's value is not very sensitive to changes in the underlying asset's price.
Interpreting Gamma Greeks in options trading involves understanding how the Gamma of an option can impact its Delta and the relationship between price changes of the underlying asset and the option's value. Gamma represents the rate at which an option's Delta changes in response to price movements in the underlying asset. The interpretation of gamma greeks is explained here.
Using Gamma Greeks in option trading can help traders assess and manage their risks and potential rewards associated with their options positions. Here's how to utilize Gamma in option trading.
Marisha Bhatt is a financial content writer @TrueData.
She writes with the sole aim of simplifying complex financial concepts and jargon while attempting to clarify technical and fundamental analysis concepts of the stock markets. The ultimate goal is to spread vital knowledge and benefit the maximum audience. Her Chartered Accountant background acts as the knowledge base to help clarify crucial concepts and create a sound investment portfolio.
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