Gamma Hedging

DEFINITION of 'Gamma Hedging'

An options hedging strategy designed to reduce or eliminate the risk created by changes in the underlying asset’s delta. Gamma hedging is closely related to delta hedging, which is designed to eliminate the risk generated by price movements in the underlying asset.

BREAKING DOWN 'Gamma Hedging'

In options, gamma refers to the rate of change for delta with respect to an underlying asset’s price. It is used to gauge movement in an option’s price relative to how in or out of the money the option is. It is common for investors to use a gamma hedge to protect themselves from the remaining exposure in a delta hedge, which is generated because delta hedges are more effective when the underlying asset has a single price.

For example, purchasing a call option for a stock and using a delta hedge by selling the underlying stock at the current price reduces risk, but only at the current spot price of the stock. It is possible that the rate of change in the stock’s price over time will stay constant, but this is unlikely. Because the rate of change itself may change over time, this creates risk since the value of the underlying asset has to change at the exact same rate as the hedge.

Using a gamma hedge in conjunction with a delta hedge requires an investor to create new hedges when the underlying asset’s delta changes. The number of shares that are bought or sold under a delta-gamma hedge depends on whether the underlying asset price is increasing or decreasing, and by how much. Because the investor is more actively purchasing shares in the underlying, a portfolio using a gamma hedge will be slightly more volatile because of a higher exposure to equities.

Several types of gamma hedges exist, including bull gamma hedges and bear gamma hedges.