INVESTING EXPLAINED: What you need to know about Gamma
In this series, we break down the jargon and explain a popular investment term or theme. Here’s the Gamma.
Worries: An increase in volatility is often a sign that confidence in the outlook for stock prices is waning as investors become anxious
Something out of a sci-fi novel?
Nothing so exciting. But this option market measure, which takes its name from the third letter of the Greek alphabet and is an indicator of stock price volatility, is increasingly appearing in stock market reports.
This reflects concerns that Wall Street’s unexpected rally this year — the S&P 500 index is up 18 percent since January — could gain momentum.
An increase in volatility is often a sign that confidence in the outlook for stock prices is waning as investors become fearful.
That’s why some analysts at major banks and brokers look very closely at the gamma positions of options traders.
Remember me. What are options?
Options are financial derivatives. You buy a “call” option if you want to acquire the right to buy a certain stock at a fixed price at a certain time in the future. If you want to sell that stock, you buy a “put” option.
Options trading, a high-risk activity, has doubled since 2020, with 10 billion contracts signed in the US alone last year.
This was partly due to the greater involvement of private investors, which started during the pandemic. But many are now participating less, have either suffered losses – or find the jargon, including terms like gamma, incomprehensible.
What does gamma mean in options trading?
Gamma is one of the ‘option Greeks’. These are the metrics used by traders to gauge the factors that can affect the value of an option – discovering whether they are going to make or lose money on the contract. The most important stats are delta, gamma, theta and vega.
Delta is an estimate of how much the value of an option can change if the value of the underlying stock rises or falls by £1 or $1. The gamma shows the rate of change between an option’s delta and the price of the underlying stock.
Theta should indicate how much the value of an option should fall as the expiration date approaches, while vega should reflect the impact of major ups and downs in the price of that underlying stock.
These calculations are performed by computers rather than humans.
This is still all Greek to me…
It’s less important to understand the math behind the calculations of gamma than it is to be aware of the behind-the-scenes role these and other metrics play toward stock markets.
Some Wall Street analysts even use their estimates of options traders’ gamma exposure as the basis for stock recommendations. If these traders think they are about to lose money on a contract, they will buy the underlying stock, which can drive up its price. This phenomenon is called a ‘gamma squeeze’.
In 2021, a division fund manager of Morgan Stanley concluded that gamma estimates suggested stocks would hold steady and made a series of lucrative deals based on that assumption, earning this individual the nickname the Gamma Hammer. It all suggests that options trading is a very complex affair. You can conclude that it is best to leave this to the professionals.