Basic Points

• Gamma is a second-order Greek which dynamically shows the rate of change of delta (directional risk) compared to the rate of change in the underlying security.
• Essentially, gamma means how fast delta changes as it moves 
• through strikes (target prices which the option contracts are based on). Another way to phrase that is that gamma shows how fast delta changes between fixed price points on a stock.
• All long options are long gamma.
• Many of our models at SpotGamma are based on aggregate gamma measurement in the market. We look at all strikes on all expirations in order to deliver comprehensive models to you which represent important structural levels that influence the range of likely price action. 
• When we measure total market gamma to be higher, what we mean is that the price is expected to trade in a smaller range.
• Stronger gamma in the market slows down the price action. 
• Also, stronger gamma at specific price levels in the market is where we expect price movement to slow down, and have a fair chance at a reversal.

Intermediate: How to Follow Changes in Market Gamma

We update models of market vanna and market gamma each day as part of our core service, which means that we are displaying the modeled vanna and gamma positioning of market makers and break down the implications of those flows in the daily reports. We also discuss these matters daily on a Discord for active SpotGamma members.

Advanced: Tactical Use Cases

How far OTM or ITM an option is also affects the behavior of gamma. When holding long OTM options, then one benefits from the offensive edge of gamma, which means that it increases deltas and therefore directional exposure as a trade becomes more and more right about direction. 

And on the other side of it, when holding long ITM options, one benefits from the defensive edge of gamma. This is because the deltas and therefore directional exposure will slow down as a trade becomes increasingly wrong about direction.

Expert: Greek Dynamics

In a way, gamma is thought of as the magic of options because the size of directional exposure (delta) increases as it is right about direction (therefore increasing profits), and it decreases when it is wrong about direction (therefore decreasing losses). But the cost for this magic is time decay.

The connection to market makers is that when they are long gamma (market gamma is positive) then they trade against the direction of the trend to lock in profits after they have favorable moves with increased size thanks to gamma. This is why positive market gamma tends to create an environment of reduced or reducing realized volatility (smaller overall price moves).

When gamma is considered not from the market perspective but from your own portfolio as a trader, this shows whether you are counting on large or small market movements. Whenever long options, you are always long gamma, long vega, and short theta. This means that you benefit sharply from spikes in IV (implied volatility) and also sharp market moves (if you are delta hedged). You can close positions for a profit or trade the underlying security against the direction of the profit for a lock on some profits as well as risk reduction; this is called gamma scalping. The game here is to make more cash from gamma scalping than is lost from theta (time decay). 

If short gamma, these dynamics become inverted, and pin risk also becomes an issue. When short options, we want small market movements so that we collect more from theta (income from time decay) than we lose from large moves. Also, if large moves end up returning to where they started, then this undoes the damage for the option seller (absent complexities from hedging). And since being short gamma means being short vega, short gamma positions benefit when IV (implied volatility) decreases. 

Regarding pin risk, what this means is that those holding short OTM (out of the money) options face increasing assignment risk when they approach the money, since they are no longer on track to pricing in an outcome where the option expires worthless.

With respect to the impact of IV on gamma itself, a decrease in IV generally increases gamma because there is more delta change in between the strikes since less IV means a smaller implied range. It also follows that, since implied volatility is proportional to the square root of time, increases in time will weaken gamma. 

Expert: Exception to the Dynamics

However, the dynamic of this general rule becomes inverted deep OTM (out of the money), in which case “the gamma will fall if we reduce [implied] volatility and rise if we increase [implied] volatility” (Natenberg, 2015, p. 151). This is a behavioral difference on the wider ranges of moneyness (how far OTM or ITM an option is). This exception is useful to know for the sake of realizing how the general rules nearer the money are not universal, but it is better to focus mostly on the general rules so as not to become distracted in understanding the dynamics.

Watch the video below for additional information on options pricing with Greeks: