What is Gamma Hedging?

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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 keeping an option position's delta neutral as the price of the underlying asset changes, especially in the final days before expiration. It is used to reduce the risk associated with large upward or downward movements in the underlying security. Gamma is an important measure of the convexity of a derivative's value in relation to the underlying asset.

Origin

The concept of gamma hedging originated from the development of option pricing theory, particularly after the introduction of the Black-Scholes model in the 1970s. Gamma, as one of the Greek letters in options, gradually became used in more complex risk management strategies.

Categories and Features

Gamma hedging is primarily used in the options market, especially during periods of high volatility. Its feature is to maintain gamma neutrality by adjusting option positions, thereby reducing the risk from large price swings in the underlying asset. The advantage of gamma hedging is its ability to provide better risk management during market turbulence, but its disadvantage is the need for frequent position adjustments, which can lead to high transaction costs.

Case Studies

Case 1: During the market turmoil in March 2020, a large hedge fund used a gamma hedging strategy to manage the risk of its technology stock options portfolio. By frequently adjusting its option positions, the fund successfully mitigated the impact of severe market volatility on its portfolio. Case 2: An investor holding Apple Inc. options used a gamma hedging strategy to maintain the stability of their portfolio during significant price fluctuations in Apple's stock, ultimately achieving profitability once the market stabilized.

Common Issues

Common issues investors face when using gamma hedging include how to effectively adjust positions to maintain gamma neutrality and how to control rising costs due to frequent trading. A common misconception is that gamma hedging can completely eliminate risk, whereas it actually only reduces the risk from large price swings.

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