DEFINITION of 'Gamma Pricing Model'

The gamma pricing model is an equation for determining the fair market value of a European-style options contract when the price movement on the underlying asset does not follow a normal distribution. The model is intended to price options where the underlying asset has a distribution that is either long-tailed or skewed such as the log-normal distribution, where dramatic market moves to the downside occur with greater frequency than would be predicted by a normal distribution of returns.

The gamma model is but one alternatives for pricing options. Others include binomial tree and trinomial tree models, for example.

BREAKING DOWN 'Gamma Pricing Model'

While the Black-Scholes option pricing model is the best known in the financial world, it does not actually provide accurate pricing results under all situations. In particular, the Black-Scholes model assumes that the underlying instrument has returns that are normally distributed in a symmetrical manner. As a result, the Black-Scholes model will tend to mis-price options on instruments that do not trade based on a normal distribution, in particular under-valuing downside puts. In addition, these errors lead traders to either over- or under-hedge their positions if they seek to use options as insurance, or if they are trading options to capture the level of volatility in an asset.

Many alternative options pricing methods have been developed with the goal of providing more accurate pricing for real-world applications such as the Gamma Pricing Model. Generally speaking, the Gamma Pricing Model measures the option's gamma, which is how much fast the delta changes with respect to small changes in the underlying asset's price (where the delta is the change in option price given a change in the price of the underlying asset). By focusing on the gamma, which is essentially the curvature, or acceleration, of the options price as the underlying asset moves, investors can account for the downside volatility skew (or "smile") resulting from the lack of a normal distribution. Indeed, the price returns of stocks tend to have a far greater frequency of large downside moves than upside swings, and furthermore stock prices are bounded to the downside by zero whereas they have an unlimited upside potential. Moreover, most investors in stocks (and other assets) tend to hold long positions, and so use options as a hedge for downside protection - creating more demand to buy lower strike options than higher ones.

The gamma model modifications allow for a more accurate representation of the distribution of asset prices and therefore better reflections of options' true fair values.

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