Gamma Hedging
Candlefocus EditorIn order to gamma hedge, an option trader must buy and sell the underlying asset in response to changes in the option's gamma. The gamma of an option is its rate of change in delta, which is an indicator of the option's sensitivity to the asset's price. By buying and selling the underlying security in response to changes in the option's gamma, traders can maintain a more balanced delta (i.e. neutralize the direction) and thus reduce their exposure to changes in the security's price.
For example, if an option trader holds a portfolio of long-call options with a net delta of +40 and their estimates of the security's price suggest a 20% increase in the near term, they would hedge out their position by selling the underlying asset 20% relative to the net delta (i.e. buying back 8 calls). This reduces the trader’s exposure in the event that the security’s price goes down but can also result in limiting any unrealized profits in the event of a rise in price of the underlying security.
Finally, gamma hedging can also be used to maturity in order to protect option positions from rapid, unexpected shifts in the underlying security's price upon expiration. This type of hedging requires monitoring of the security’s gamma throughout the option's lifetime and buying and selling of the underlying asset in a manner that preserves the trader's delta neutral position relative to the delta of the option's gamma.
Overall, gamma hedging is a sophisticated risk management strategy used by option traders to reduce their exposure to large and unexpected price movements in underlying securities. By monitoring the option’s gamma and taking into account the trader’s current position delta, traders can often limit their downside risk while simultaneously avoiding limitations on potential profits. As such, gamma hedging is an important tool that can be used to improve the potential performance of an overall options trading strategy.