What Is Gamma Hedging?

What Is Gamma Hedging?

Let me explain gamma hedging directly: it's a trading strategy where you aim to keep a constant delta in your options position, especially if it's delta-neutral, as the underlying asset's price shifts. You use this to cut down risks from big up or down moves in the security, particularly in those final days before expiration.

Your option position's gamma shows how its delta changes for every 1-point move in the underlying asset's price. Gamma highlights the convexity of a derivative's value tied to that asset. In contrast, a delta hedge only softens the impact of small price changes on the option's value.

How Gamma Hedging Works

A gamma-neutral options position is one you've protected against large swings in the underlying security. You achieve this by building a portfolio where the delta's rate of change is near zero, no matter if the underlying goes up or down. That's gamma hedging in action—it hedges against second-order price sensitivity over time.

To gamma hedge, you add more option contracts to your portfolio, typically opposing your current stance. For instance, if you're holding a bunch of calls, you might throw in a small put position to buffer against a sudden price drop in the next day or two, or sell some calls at a different strike. This is complex stuff, so you need precise calculations to get it right.

Gamma vs. Delta

Gamma gets its name from the Greek letter in the Black-Scholes Model, the go-to formula for pricing options. In that model, delta and gamma are key variables that show how option prices react to moves in the underlying security.

Delta indicates how much an option's price should shift with a one-dollar change in the underlying stock or asset. Gamma, on the other hand, tracks how the option's delta changes with that same price move in the underlying—it's basically the rate of change for the option's price itself. Some traders see gamma as the adjustment for a second one-dollar shift, so adding gamma to delta gives you the expected impact from a two-dollar move.

Delta-Gamma Hedging

Delta-gamma hedging merges delta and gamma hedges to reduce risks from changes in the underlying asset and in the delta as the asset moves. Delta hedging alone covers small shifts, but big ones can alter the delta and expose your position. Adding a gamma hedge keeps that delta hedge solid.

When you use gamma with delta hedging, you must adjust hedges as the underlying's delta changes. The shares you buy or sell depend on whether the asset's price is rising or falling, and by how much. If you're aiming for delta-hedged or delta-neutral, you're betting on volatility shifts without much short-term price impact. But near expiration, delta hedging falls short because even normal fluctuations can spike option prices due to low time value. That's where gamma hedging steps in to guard against larger-than-expected changes, especially when time value is nearly gone.

Important Note on Delta-Gamma Positions

Often, you'll aim for a delta-gamma hedge that's delta-neutral, but you might prefer a specific delta—positive or negative—while keeping it gamma-neutral.

Gamma Hedging vs. Delta Hedging

As I've mentioned, delta and gamma hedging go hand-in-hand. You can set up a basic delta hedge by buying calls and shorting shares of the underlying stock. If the stock price stays put but volatility climbs, you might profit, unless time decay eats it away. Adding a short call at another strike offsets that decay and protects against delta shifts—that's your gamma hedge.

As the stock value fluctuates, you may need to buy or sell shares to stay neutral, which can ramp up volatility and costs. You don't have to make delta or gamma completely neutral; you can tweak your exposure to positive or negative gamma as needed.

Disclaimer

Remember, this isn't tax, investment, or financial advice. The info here doesn't account for your specific objectives, risk tolerance, or situation, and it may not suit everyone. Investing carries risks, including potential loss of principal.