What is gamma?
An option?s price changes with fluctuations in several factors such as spot price, volatility, interest rates and time. Delta is a measure of the change in option premium with respect to a change in the underlying, or spot, price. Gamma represents the change in delta for a given change in the spot rate.
In trading terms, players become long gamma when they buy standard puts or calls, and short gamma when they sell them. When commentators speak of the entire market being long or short gamma, they usually are referring to market-makers in the interbank market.
How market makers view gamma
Let?s consider how market makers view gamma. Generally, options market makers seek to be delta-neutral?that is, they want to hedge their portfolios against movement in the underlying spot rate. The amount by which their delta, or hedge ratio, changes is known as gamma.
Say a trader is long gamma, meaning that she has bought some standard vanilla options. Assume they are USD/JPY options. If we further assume that the delta position of these options is $10 million at USD/JPY 107, she will need to sell $10 million USD/JPY at 107 in order to hedge and be fully insulated against spot movement.
If USD/JPY rises to 108, she will need to sell another $10 million, this time at 108, as the total delta position becomes $20 million. What happens if USD/JPY goes back to 107? The delta position goes back to $10 million, as before. Because she is now short $20 million, the trader will need to buy back $10 million at 107. The net effect then is that she makes a 100-pip profit, selling and 108 and buying at 107.
Therefore, when traders are long gamma, they are continually buying low and selling high, or vice-versa, in order to hedge. When the spot market is very volatile, traders will be earning a lot of profits through their hedging activity. But these profits are not free, as they have paid a premium to own the options. In theory, the amount one makes from delta hedging should exactly offset the premium. Whether or not this is the case depends on the actual volatility of the spot rate.
The reverse is true when a trader has sold options. As she is short gamma, in order to hedge she must continually buy high and sell low?thus she loses money on her hedges, in theory the exact same amount that she earns in option premium through her sales.
Why is gamma important for spot traders?
But what relevance does all this have for regular spot traders? The answer is that spot movement is increasingly driven by what goes on in the options market. When the market is long gamma, market-makers as a whole will be buying spot when it rises and selling spot when the exchange rate falls. This behavior generally can keep the spot rate in a relatively tight range.
When the market is short gamma, however, the spot rate can be prone to wide swings as players are either continually selling when prices fall, or buying when prices rise. A market that is short gamma will exacerbate price movement through its hedging activity. Thus:
- Market-makers long gamma: Spot generally will trade in a tighter range
- Market-makers short gamma: Spot can be prone to wide swings