Delta-Gamma Hedging

DEFINITION of 'Delta-Gamma Hedging'

An options hedging strategy that combines a delta hedge and a gamma hedge. A delta-gamma hedge is designed to reduce or eliminate the risk created by changes in the underlying asset’s price, as well as variances in how much the price changes.

BREAKING DOWN 'Delta-Gamma Hedging'

In options, delta refers to a change in the price of an underlying asset, while gamma refers to the rate of change of delta. They are used to gauge movement in an option’s price relative to how into or out of the money the option is. Investors use a gamma hedge to protect themselves from the remaining exposure created through the use of a delta hedge, which is generated because delta hedges are more effective when the underlying asset has a single price.

A delta-gamma hedge requires the purchase of shares and a call option, while selling a call option at another strike price. The goal of the hedge is to eliminate both gamma and delta for the shares. The delta option component involves selling options to produce a negative delta.

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 the underlying shares, a portfolio using a gamma hedge will be slightly more volatile because of a higher exposure to equities.

Large hedges that involve buying or selling significant quantities of shares and options may have the effect of changing the price of the underlying on the market, requiring the investor to constantly and dynamically create hedges for a portfolio to take into account greater fluctuations in prices.