Options strategies can vary in nature, well beyond speculating on the direction of an underlying security or benefiting from time decay. For traders that are looking to benefit from increased implied and historical volatility there are strategies that can be employed that earn income as an underlying security gyrates. This type of strategy not only benefits from increasing implied volatility but also earns income as the underlying security changes in price.
The gamma of an option is a Greek term used to describe the change in delta due to a change in the underlying security. As a security moves above or below the strike price of the option not only does the value of the option change, but the theoretical delta of the option changes as well. The delta of an option is the theoretical number of shares owned by the option purchaser based on the number of options held, as well as, the underlying prices relative to the strike price.
For example, if an option investor purchases 1 Facebook $25 call option that expires in 30 days when the underlying price of Facebook is $25, the delta of the option would likely be approximately 50%. This means that the option owner theoretically has exposure to 50 shares of Facebook and will earn $50 for every $1 increase in the value of Facebook.
As the price of Facebook rises, the option gains in value and the delta of the option increases to reflect that increased value. The change in the delta relative to the change in the price is referred to as the gamma of the option. One way for a trader to benefit from this change in value is to monetize the value by locking in the theoretical number of shares. This process is generally referred to as delta hedging.
For example, if Facebook were to move higher to $30 dollars a share, the delta of the option would increase to 70%. The increase in the underlying shares increased the delta of the option by 20 shares. To capture this increase, an investor could sell short 20 shares of the underlying security reducing the theoretical number of shares owned back to 50.
From this point, if Facebook stock increased to $35 per share, the investor would lose $5 on 20 shares of stock and gain $5 on the theoretical option shares. If the prices decreased to $25, the traders would gain $5 on the short stock position and lose $5 on the theoretical options position.
Trading the gamma of an option is similar to trading the historical volatility of the underlying security and can also be used when binary options and spread trading. Gamma traders are looking for a security to gyrate so they can capture the movements of an underlying security when the historical volatility of a security is greater than the implied volatility that is price into the option initially.