Understanding Gamma and How It Costs You Money

A reader writes:
 

I’m hoping for a more in-depth “beta” on gamma. I'm hoping you will address trading gamma in an article; how you use gamma to spot trading opportunities, with specific examples from where you sit, with your time horizons, and so forth.

Basically, gamma can refer to two things: First, it can mean the gamma of an individual option -- which is the rate at which the delta of the option will change per one-point move in the underlying. Let's say an option has a delta of .50 and a gamma of .10. That means that if the stock goes up a point, the delta of that option is now .60. Second, gamma can also refer to an entire position. Say you're long 500 XYZ with a gamma of 100. If XYZ rallies a point, you are now long 600 XYZ.

(Editor's Note: For more on options terminology, see Steve Smith's The Fraternity of Options Trading.)

As to how to use gamma to spot trading opportunities, I'm not exactly sure. Your gamma is your gamma. If it's positive, you can fade into moves. The question is then, how aggressively. If it's a trend day, you want to be patient as it probably ends low and last or high and last; if it's a range day, you want to be in there flipping stock. If it's negative, well, the opposite. You want to be as patient as possible, but know there are times you'll have to sell weakness or chase strength in order to defend a position.

The key point is that gamma costs money in the form of time decay (theta). If gamma is high relative to theta, it means volatility is cheap. Of course you can just look at volatility and see it's cheap. And as we know too well, cheap volatility isn't always good volatility to buy; you basically get what you pay for unless you're lucky (or skillful) enough to time the occasional turn.