What is Gamma Hedging?

Gamma hedging is an options hedging strategy used to reduce the risk created when the underlying security makes strong up or down moves, particularly during the last day or so before expiration.

Key Takeaways

  • Gamma hedging is a sophisticated option strategy used to reduce risk in special circumstances.
  • The risk of an option price moving rapidly shortly before expiration is what gamma hedging often seeks to neutralize.
  • Large, unexpected moves can also be addressed with gamma hedging.
  • Gamma hedging is the next line of defense for a trader after delta hedging.

How Gamma Hedging Works

Gamma hedging consists of adding additional option contracts to an investors portfolio, usually in contrast to the current position. For example, if a large number of calls were being held in a position, then a trader might add a small put-option position to offset an unexpected drop in price during the next 24-48 hours, or sell a carefully chosen number of call options at a different strike price. Gamma hedging is a sophisticated activity that requires careful calculation to be done correctly.

Gamma is the Greek-alphabet inspired name of a standard variable from the Black-Scholes Model, the first formula recognized as a standard for pricing options. Within this formula are two particular variables that help traders understand the way option prices change in relation to the price moves of the underlying security: Delta and Gamma.

Delta tells a trader how much an option's price is expected to change because of a small change in the underlying stock or asset--specifically a one-dollar change in price.

Gamma refers to the rate of change of an option's delta with respect to the change in price of an underlying stock or other asset's price. Essentially, gamma is the rate of change of the rate of change of the price of an option. However some traders also think of Gamma as the expected change resulting from the second consecutive one-dollar change in the price of the underlying. So that by adding Gamma and Delta to the original Delta, you'd get the expected move from a two-dollar move in the underlying security.

A trader who is trying to be delta-hedged or delta-neutral is usually making a trade that has very little change based on the short-term price fluctuation of a smaller magnitude. Such a trade is often a bet that volatility, or in other words demand for the options of that security, will trend towards a significant rise or fall in the future. But even Delta hedging will not protect an option trader very well on the day before expiration. On this day, because so little time remains before expiration, the impact of even a normal price fluctuation in the underlying security can cause very significant price changes in the option. Delta hedging is therefore not enough under these circumstances.

Gamma hedging is added to a delta-hedged strategy to try and protect a trader from larger than expected changes to a security, or even an entire portfolio, but most often to protect from the effects of rapid price change in the option when time value has almost completely eroded.

Gamma Hedging vs. Delta Hedging

A simple delta hedge could be created by purchasing call options, and shorting a certain number of shares of the underlying stock at the same time. If the stock's price remains the same but volatility rises, the trader may profit unless time value erosion destroys those profits. A trader could add a short call with a different strike price to the strategy to offset time value decay and protect against a large move in delta; adding that second call to the position is a gamma hedge.

As the underlying stock rises and falls in value, an investor may buy or sell shares in the stock if she wishes to keep the position neutral. This can increase the trade's volatility and costs. Delta and gamma hedging don't have to be completely neutral, and traders may adjust how much positive or negative gamma they are exposed to over time.