Gamma Hedging
Gamma hedging is a trading strategy that tries to maintain a constant delta in an options position, often one that is delta-neutral, as the underlying asset changes price. It is used to reduce the risk created when the underlying security makes strong up or down moves, particularly during the last days before expiration.An option position's gamma is the rate of change in its delta for every 1-point move in the underlying asset's price. Gamma is an important measure of the convexity of a derivative's value, in relation to the underlying asset. A delta hedge strategy, in comparison, only reduces the effect of relatively small underlying price changes on the options price.
Definition: Gamma hedging is a trading strategy aimed at maintaining a delta-neutral position in options holdings as the price of the underlying asset changes, especially in the final days before expiration. Gamma hedging is used to reduce the risk of significant price movements in the underlying security. Gamma measures the convexity of the derivative's value in relation to the underlying asset.
Origin: The concept of gamma hedging originated from the development of options pricing theory, particularly the application of the Black-Scholes model. As financial markets became more complex, investors realized that simple delta hedging could not fully mitigate risks, leading to the introduction of gamma hedging as a more refined risk management strategy.
Categories and Characteristics: Gamma hedging can be divided into static gamma hedging and dynamic gamma hedging. Static gamma hedging involves setting the hedge position initially and not adjusting it, while dynamic gamma hedging requires continuous adjustment of the position based on market changes. Static gamma hedging is simpler to execute but may not handle significant market volatility, whereas dynamic gamma hedging is more flexible but complex and costly.
Specific Cases: Case 1: Suppose an investor holds a call option with the underlying asset priced at $100 and a gamma of 0.05. If the underlying asset price rises to $105, the gamma hedging strategy would require the investor to sell a certain amount of the underlying asset to maintain a delta-neutral position. Case 2: If the underlying asset price drops to $95, the gamma hedging strategy would require the investor to buy a certain amount of the underlying asset to maintain a delta-neutral position. These actions effectively reduce the risk associated with significant price movements in the underlying asset.
Common Questions: 1. What is the difference between gamma hedging and delta hedging? Gamma hedging is more refined and can handle significant price movements in the underlying asset, while delta hedging primarily addresses small price movements. 2. What are the costs of gamma hedging? Gamma hedging requires frequent position adjustments, making it more costly to execute.
