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An important part of trading stocks is knowing how sensitive they are to changes. Gamma hedging, also called gamma scalping, helps you avoid risks when dealing with stock options and gives you an easy way to measure risk. A stock option gives you the ability to buy or sell a stock when it reaches a certain price. Here’s some more information about what gamma hedging is, how it works, and how you can use it to reduce your investment risks.
What Is Gamma?
A stock option’s gamma is a risk measurement that looks at the rate of change of its delta. Delta is the ratio of a change in option value to a change in stock value.
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Gamma changes depending on where the stock price is in relation to the option’s strike price. Gamma is highest when the stock price is near the strike price and lowest when it’s completely different. These gamma options are usually closer to expiration. Options that are deep in the money or out of the money have gammas close to zero.
How Does Delta and Gamma Hedging Work?
You can reduce your risks with delta and gamma hedging. A simple delta hedge would involve purchasing call options that should increase in price if stock value increases. Then, you would short a certain number of shares or sell them early. If the stock price doesn’t change much but market volatility rises, you can still profit.
When you add gamma hedging to this strategy, you also use a short call with a different strike price. This means you can sell the call options if the stock price decreases, shielding yourself from larger losses and a large change in delta. As stock prices rise and fall, you can buy or sell shares to keep gamma and delta the same. However, delta and gamma hedging don’t need to be totally neutral, and you can choose how much gamma you’re comfortable with for each trade.
Delta is only an approximation of changes in option prices and stock prices. In reality, changes in option prices are not linear. A delta-neutral portfolio will still have changes in gamma. Hedging your portfolio for delta and gamma can help you reduce risk and increase profits.
Gamma Hedging Example
An at-the-money call option for $100 has a 0.5 or 50% delta and a gamma of 10. You can use delta hedging to reduce its risk. If you have 100 options, you would hedge by selling 50. If the stock price falls to $99, the price of the option will change by about 10 cents, one-tenth of the change in the stock price. This lowers the delta to 0.4 or 40%, making the original delta hedge too large. To correct this problem, you can buy back 10 shares of stock from the 50 you sold. Since the price just dropped, you’ll save $1 per share, or $10.
Conclusion: Reduce Investment Risk
Gamma hedging lets you adjust your portfolio in response to changes. That way, you can avoid risks and increase your profits.