In Chapter 9, we considered the primary Greeks; delta, theta, vega and rho. Remember that the primary Greeks tell us how much an option price should change in response to changes in the underlying share price, time, volatility and interest rates.
The most important of the secondary Greeks is gamma which tells us how much an option delta should change in response to a move in the underlying. For example, other things being equal, if the delta of the Sep FTSE 5825 call is 0.500 (or 50.0%) at the current underlying price of 5825 and would be 0.501 (or 50.1%) if the underlying FTSE rose by 1 tick to 5826, then the gamma of the Sep 5825 call is 0.001 (or 0.1%), the difference between the delta of the call at the different underlying prices.
Because gamma tends to be of a relatively small magnitude for a 1 tick move in the underlying, traders in the real world tend to look at gamma over larger movements. So much for the theory, what of practice? How do option traders use “gamma”? How do we “trade gamma”? Consider the following FTSE example. For the purposes of clear illustration, the numbers used in our example are both exaggerated and rounded.
We are speculators in FTSE options. We are not looking to hedge an existing position. We are simply looking to trade FTSE options profitably. We believe that the FTSE will be volatile over the coming period and that FTSE options are currently underpriced. We do not have a directional view. We believe that the market will move ...