What is Gamma Hedging
Gamma hedging is an options hedging strategy designed to reduce, or eliminate the risk created by changes in an option's delta.
BREAKING DOWN Gamma Hedging
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. Since delta can experience fast changes that are not in the investor's favor, gamma hedging may help to reduce that risk.
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. A trader who is trying to be delta-hedged or delta-neutral is usually making a trade that volatility will rise or fall in the future. Gamma hedging is added to a delta-hedged strategy to try and protect a trader from larger changes in the portfolio than expected or time value erosion.
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.