Gamma hedging is a trading strategy followed by investors to reduce the risk of market volatility. This strategy is used by option traders when they feel they will lose their money if the market goes in the opposite direction than expected. In this article, we will explain what options are and how option traders lead to gamma hedging.
What are Options?
Options are the financial derivatives that give the investors the right to buy or sell an underlying security at a strike price. These derivatives give the right but not the obligation as the buyer may or may not exercise his options. There are mainly two types of options, “Call” and “Put” options. Both of these options are utilized by the investors to gain profit or to hedge their losses. ETF investors, mutual fund investors, or SPAC investors, all do options trading to maintain their investment portfolio.
Call options give the buyer the right but not the obligation to buy shares of an underlying stock at a set price within the specified time. These options give investors more coverage of the stock market with less investment.
Before the expiration period, if
Stock > set price + option purchase price
Then the investor can purchase the stocks at a discount. If not then the stock price will be at a premium and the investor may or may not purchase the stock. After the expiration period, the investment done on the options will be lost.
Put options are just the opposite of the call options. That is, a put option gives the buyer the right to sell the stocks at a set price within the specified period. These options help the investors hedge their losses during the market crash. They are like doing the insurance of your share.
Before the expiration period, if
Stock Price < Set Price + Option Purchase Price
Then the trader can sell the stocks and hedge his/her loss. If not then the investor will not sell the stocks as they will be at a discounted rate. After the expiration period, the investment done on the options will be lost.
What is Theta?
Theta in options trading is the rate of declination of an option’s value with the passage of time. That is, an option will lose its value as time moves closer to the expiration date, as long as the market is held constant. It is one of the option greeks that measures the rate at which the option loses its value with time.
This means if there is more time for both calls and puts to reach maturity, the more these options will be worth. It is because with more time there is a higher potential for the price movement of the underlying stocks which gives the option more value.
With more time for maturity, the volatility will increase which in turn drives up the price of both calls and puts. The option price is directly related to volatility. Higher the volatility higher will be the option value. Traders will measure the probability of the change in price of the underlying security. The change will be calculated in terms of percentage or standard deviation over a course of time. Higher the standard deviation (i.e. high implied volatility) higher will be the price swing in either direction (i.e. up or down).
What is Gamma Hedging?
Gamma hedging is an options trading strategy that is used to reduce the risk created by the strong ups and downs of the underlying security. Here, the term gamma refers to the rate of change of an option’s delta with respect to the change in underlying stock price. Where the delta is the value by which the option price will move relative to the movement of the underlying stock price. If the stock price is trading below the set price of the call option, the delta will be closer to 0. This means the fluctuation in the call option price will also be closer to 0. If it is closer to 1, a very high fluctuation in the option price will be seen.
A lot of call option trading between the option traders and market makers can lead to a gamma squeeze. It is a scenario where the stock price will rise indefinitely. When there is a large volume of call options are traded by market makers hoping that the stock price will fall. Now if the price of the underlying stock rises, these market makers will bear a huge loss. To hedge this loss, they start buying the common stock at market price which in turn acts as the fuel to raise the stock price even higher.
Another way to perform a gamma hedge is to use the technique of gamma neutral. A gamma neutral is a position of an option that is immune to large price fluctuation of the underlying security. Gamma neutrality can be achieved by delta neutrality. The idea here is to set the option position when the overall gamma value is as close to zero as possible. As the gamma is near zero, which means the delta will be less prone to the price fluctuation of the underlying security.
A simple technique will be to purchase call options and at the same time perform short selling. If the price falls, shorting will help, and if rises call options will help. This means the overall effect of market fluctuation will be less, and if the stock price did not move but the volatility rises, the trader can make a profit.
Gamma Hedging is the action performed by the investors (market makers) to reduce their losses when there is a surge in the market price. If the price of the underlying stocks goes one way, then the option traders may have to buy the stocks to hedge from the loss due to options trading.
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