What is Gamma Neutrality?
A gamma neutral option position is an option position that is immune to large swings in the underlying security. Achieving a gamma-neutral position is a method of managing options trading risk by building a portfolio of assets whose delta rate of change is close to zero even if the underlying asset rises or falls. This is called a gamma hedging. Therefore, a gamma-neutral portfolio hedges second-order time-price sensitivity.
Gamma is one of the “Greeks of Choice” along with delta, rho, theta and vega. These are used to assess different types of risk in an options portfolio.
- A gamma neutral portfolio is an option position that does not change its delta even if the underlying security rises or falls sharply.
- Gamma neutrality is achieved by adding additional options contracts to a portfolio, often in contrast to current positions in a process known as gamma hedging.
- Delta-gamma hedging is often used to lock in profits by creating a delta-neutral, gamma-neutral position.
Understanding Gamma Neutrality
Directional risk in options portfolios can be managed by delta hedging, creating delta neutral or directional contradictory portfolios. The problem is that the delta of an option itself changes as the underlying price moves, which means that a delta-neutral position can gain or lose delta and become a directional bet, especially if the underlying price moves significantly. Gamma hedges try to offset this change in delta.
A gamma-neutral portfolio can be created by taking positions that offset gamma. This helps reduce variability due to changes in market prices and conditions. However, a gamma-neutral portfolio remains risky. For example, an otherwise neutral position can become risky if the assumptions used to build the portfolio turn out incorrectly. Additionally, positions must be rebalanced as prices change and time passes.
The Gamma Neutral Option Strategy can be used to create new safe positions or adjust existing positions. The goal is to use a combination of options to get the overall gamma as close to zero as possible. At values close to zero, when the price of the underlying security moves, the delta value should not move.
Note that delta-gamma hedging can be used if the goal is to achieve a durable delta neutral strategy. Alternatively, however, a trader may wish to maintain a specific delta position, where it may be delta positive (or negative) but gamma neutral.
Locking in profits is a popular use of gamma neutral positions. A delta-neutral or gamma-neutral hedging can effectively lock in profits if a period of high volatility is expected and options trading positions have made decent profits so far, rather than selling positions to lock in profits and no longer receive any returns. .
Gamma Neutral and Delta Neutral
A simple delta hedge can be created by buying a call option and simultaneously shorting a certain amount of the underlying stock. If stock prices remain unchanged but volatility rises, traders may make profits unless time value erosion destroys those profits. A trader can add a short call option with a different strike price to the strategy to offset time value decay and prevent large swings in delta. Adding a second call to the position is a gamma hedge.
As the underlying stock appreciates and depreciates, investors can buy or sell shares if they wish to maintain a neutral position. This increases the volatility and cost of trading. Delta and gamma hedges do not have to be completely neutral, traders can adjust the positive or negative gamma they are exposed to over time.