Gamma is a measurement of how fast the delta of an option’s price changes after a 1point movement in the underlying security. Delta is the rate of change in an option’s price after a change in value of the underlying stock. While delta represents the speed at which the option price changes, gamma shows the rate at which it accelerates. The larger the gamma is, the more volatile the price of the option is.
Options priced at or near the money will have a larger gamma. Options priced deep in or deep out of the money will result in smaller gamma. This is because when an option is near or at the money, a small change in the underlying asset’s value can have a big impact on the level of demand for the contract. If the options are deep in or deep out of the money, demand will not change as much from changes in the asset’s value.
Say the stock for XYZ Company is priced at $50 and its strike price is also $50, or at the money. The option is priced at $3. A $1 increase in the underlying stock price will result in a $.50 increase to $3.50 in the option price if the delta is .5. If the underlying stock’s value rises another $1 to $52, the option’s delta will increase to .55, putting the price at $3.55. That acceleration in delta of $.05 represents the gamma.
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