INVESTMENT EXPLAINED: What you need to know about Gamma
In this series, we break down the jargon and explain a popular investment term or topic. Here is Gamma.
Something from a science fiction novel?
Nothing that exciting. But this options market metric, which takes its name from the third letter of the Greek alphabet and is an indicator of stock price volatility, has been appearing more frequently in stock reports. This reflects concerns that Wall Street’s unexpected rebound this year — the S&P 500 index is up 18 percent since January — might be running out of steam.
An increase in volatility is often a sign that confidence in the outlook for stock prices is waning, as investors grow fearful.
This is why some analysts at major banks and brokers are watching options traders’ gamma positions very closely.
Remember me. What are the options?
Options are financial derivatives. You buy a ‘call’ option if you want to acquire the right to buy a certain share at a fixed price at some point in the future. If you want to sell that stock, you buy a ‘put’ option.
Concerns: An increase in volatility is often a sign that confidence in the outlook for stock prices is waning, as investors grow fearful.
Options trading, an activity with great risks, has doubled since 2020, with 10 billion contracts in the US alone last year.
This was partly a result of the increased participation of private investors, which began during the pandemic. But many are now participating less, either because they have taken losses or found jargon, including terms like gamma, incomprehensible.
What is the importance of gamma in options trading?
Gamma is one of the ‘Greek options’. These are the metrics used by traders to assess the factors that can influence the value of an option and thus discover whether they are going to make or lose money on the contract. The key metrics are delta, gamma, theta, and vega.
Delta is an estimate of how much an option’s value may change given a £1 or $1 movement, either up or down in the value of the underlying stock. The gamma shows the rate of change between an option’s delta and the price of the underlying stock.
Theta should show how much an option’s value should decrease as the expiration date approaches, while vega should give a picture of the influence of big swings on the price of that underlying stock.
These calculations are done by computers instead of humans.
This is still all Greek to me…
It is less important to understand the mathematics behind gamma calculations than to be aware of the role that gamma and other metrics play, behind the scenes, in the direction of stock markets.
Some Wall Street analysts even use their estimates of options traders’ gamma exposure as the basis for stock recommendations. If these traders think they are about to lose money on a contract, they will buy the underlying stock, which can push its price up. This phenomenon is called ‘gamma squeeze’.
In 2021, a fund manager at a division of Morgan Stanley concluded that gamma estimates suggested stocks would hold steady and made a series of lucrative deals based on that assumption, earning this person the nickname Gamma. Hammer. Everything suggests that options trading is a very complex affair. You may conclude that it is better to leave it in the hands of professionals.