Option Insights – Trading the Greeks (Part 2 of 4):Gamma Effects# Option Insights – Trading the Greeks (Part 2 of 4)
## Option Convexity and Gamma Effects
### Gamma – The Convexity of Options
Gamma measures how much the Delta of an option changes in response to movements in the underlying asset’s price. Mathematically, it is the second derivative of the option’s value with respect to the price of the underlying. In simpler terms, Gamma quantifies the curvature—or convexity—of the option’s price sensitivity.
- Positive Gamma: Accelerating Delta as the underlying moves.
- Negative Gamma: Decelerating Delta as the underlying moves.
This convexity becomes especially important for traders managing exposure. A directional trader might seek:
- Positive Gamma near anticipated breakouts to increase exposure during favorable moves.
- Negative Gamma in areas where they want to taper exposure, such as in covered call setups (where the short call reduces gains as price rises).
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## Gamma and Delta Hedging
Traders who Delta hedge their option positions using the underlying (or a Delta-1 instrument) face the reality of nonlinearity: Delta changes as the market moves, and Gamma determines how fast.
In practice, this means hedgers must adjust frequently to maintain a neutral Delta—Gamma tells them how often and how aggressively.
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## Hedging a Position with Positive Gamma
When hedging and holding positive Gamma:
- If the underlying price rises → Delta increases → Sell the underlying.
- If the underlying price falls → Delta decreases → Buy the underlying.
This results in countercyclical trading, i.e., trading against the market trend.
**Advantages:**
- Potentially dampens volatility.
- Allows for limit order execution (e.g., sell at offer when price rises), capturing bid-offer spreads.
- Automated or semi-automated setups possible.
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## Hedging a Position with Negative Gamma
With hedging and holding negative Gamma, the adjustments are procyclical:
- Price rises → Delta drops → Buy more underlying.
- Price falls → Delta rises → Sell more underlying.
**This means:**
- You're chasing the market, increasing exposure in the direction of the move.
- You likely cross the spread to ensure execution (lifting the offer or hitting the bid).
- This behavior tends to amplify volatility and incurs transaction costs.
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## Summary: Gamma's Impact on Hedging
- Long Gamma → Hedge countercyclically, dampen market movements, and potentially profit from spreads.
- Short Gamma → Hedge pro-cyclically, amplify market movements, and pay the spread.
This distinction underscores a critical point: hedging Delta is not just about neutralizing exposure—it’s about managing how that exposure evolves, which is precisely what Gamma represents.
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## Can You Hedge Delta Without Gamma Risk?
**In theory?** Yes.
**In practice?** Not really.
Hedging an option (a nonlinear instrument) with the underlying (a linear one) means you’re using a linear approximation of a curved payoff structure. This hedge is only locally accurate—it must be rebalanced frequently to remain effective.
While it’s theoretically possible to hedge both Delta and Gamma using other options, this introduces complexity:
- Other Greeks (like Theta and Vega) enter the equation.
- Option hedges are often illiquid, expensive, or difficult to scale.
For most traders, hedging Delta with the underlying remains the simplest, most liquid, and most cost-effective approach—despite the need for Gamma-based adjustments.
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## Gamma Trading & Gamma Scalping
Even in non-directional strategies, Gamma has value.
Gamma scalping involves actively trading the underlying around an options position to exploit short-term price swings:
- You buy low and sell high as the underlying fluctuates,
- Profiting from volatility, not direction.
This is a powerful technique for monetizing Gamma, particularly when implied volatility is elevated relative to realized moves.
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## Coming Up Next:
📘 Part 3: Gamma Scalping – Monetizing Convexity Through Active Hedging
by parsifaltrading
