Gamma of an Option

What is the Gamma of an Option in Finance?

The term “gamma of an Option” refers to the range of the change in the delta of an option in response to the unit change in the price of the underlying asset of the option. Gamma can be expressed as the second derivative of the premium of the optionOptionOptions are financial contracts which allow the buyer a right, but not an obligation to execute the contract. The right is to buy or sell an asset on a specific date at a specific price which is predetermined at the contract date.read more with respect to the price of the underlying asset. It can also be expressed as the first derivative of the delta of the option with respect to the price of the underlying asset.

The formula for gamma function can be derived by using a number of variables, which include asset dividend yield (applicable for dividend-paying stocks), spot price, strike price, standard deviation, option’s Time to expiration, and the risk-free rate of returnRisk-free Rate Of ReturnA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk.read more.

Mathematically, the gamma function formula of an underlying asset is represented as,

Gamma Formula
Gamma--Function-Formula

You are free to use this image on your website, templates etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Gamma of an Option (wallstreetmojo.com)

where,

For non-dividend paying stocks, the gamma function formula can be expressed as,

Gamma Formula2

Explanation of the Gamma Option in Finance

The formula for gamma in finance can be derived by using the following steps:

  1. Firstly, the spot priceSpot PriceA spot price is the current market price of a commodity, financial product, or derivative product, and it is the price at which an investor or trader can buy or sell an asset or security for immediate delivery.read more of the underlying asset from the active market, says the stock market for an actively traded stock. It is represented by S.

  2. Next, determine the strike price of the underlying asset from the details of the option. It is denoted by K.

  3. Next, check whether the stock is paying any dividend, and if it is paying, then note the same. It is denoted by d.

  4. Next, determine the maturity of the option or Time to expiration, and it is denoted by t. It will be available as details pertaining to options.

  5. Next, determine the standard deviation of the underlying assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.read moreUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.read moreUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.read more, and it is denoted by ơ.

  6. Next, determine the risk-free rate of return or asset return with zero risks for the investor. Usually, the return of government bonds is considered the risk-free rate. It is denoted by r.

  7. Finally, the formula for the gamma function of the underlying asset is derived by using the asset’s dividend yieldDividend YieldDividend yield ratio is the ratio of a company's current dividend to its current share price.  It represents the potential return on investment for a given stock.read moreDividend yield ratio is the ratio of a company's current dividend to its current share price.  It represents the potential return on investment for a given stock.read moreDividend yield ratio is the ratio of a company's current dividend to its current share price.  It represents the potential return on investment for a given stock.read more, spot price, strike price, standard deviation, option’s Time to expiration, and a risk-free rate of return as shown below.

    Gamma Formula

Example of Gamma Option Finance Formula (with Excel Template)

Let us take the example of a call optionThe Example Of A Call OptionCall Options are derivative contracts that enable the buyer of the option to exercise his right to buying particular security at a pre-specified price popularly known as strike price on the date of the expiry of such a derivative contract. It is important to note that the call option is a right, not an obligation.read more with the following data.

Example 1

Also, calculate the gamma at spot price

  • $123.00 (out of money)
  • $135.00 (at the money)
  • $139.00 (in the money)

(i) At S = $123.00,

d1 = [ln (S / K) + (r + ơ2/2) * t] / [ơ * √t]

= [ln ($123.00 / $135.00) + (1.00% + (30.00%)2/2) * (3 / 12)] / [30.00% * √(3 / 12)]

= -0.3784

Therefore, the gamma function calculation of the option can be calculated as,

Option’s gamma S=$123.00

= e-[d12/2  + d*t] / [(S*ơ) * √(2ℼ*t)]

= e-[0.22352 /2+ (3.77% * 3/12)] / [($123.00 * 30.00%) * √(2π * 3/12)]

= 0.0193

(ii) At S = $135.00,

d1 = ln (S / K) + (r + ơ2/2) * t] / [ơ * √t]

= [ln ($135.00 / $135.00) + (1.00% + (30.00%)2/2) * (3 / 12)] / [30.00% * √(3 / 12)]

= 0.2288

Therefore, the gamma function calculation of the option can be calculated as,

Option’s gamma S=$135.00

= e-[d12/2 + d*t] / [(S*ơ) * √(2ℼ*t)]

= e-[ 0.22352 /2+ (3.77% * 3/12)] / [($135.00 * 30.00%) * √(2π * 3/12)]

= 0.0195

(iii) At S = $139.00,

d1 = [ln (S / K) + (r + ơ2/2) * t] / [ơ * √t]

= [ln ($139.00 / $135.00) + (1.00% + (30.00%)2/2) * (3 / 12)] / [30.00% * √(3 / 12)]

Example 1.1jpg

= 0.2235

Therefore, the gamma function calculation of the option can be calculated as,

Example 1.2jpg

Option’s gamma S=$139.00

= e-[d12/2 + d*t] / [(S*ơ) * √(2ℼ*t)]

= e-[ 0.22352 /2+ (3.77% * 3/12)] / [($139.00 * 30.00%) * √(2π* 3/12)]

= 0.0185

For a detailed calculation of gamma, function refer the given excel sheet above.

Relevance and Uses

It is important to understand the concept of gamma function because it helps in the correction of convexityConvexityConvexity of a bond is a measure that shows the relationship between bond price and yield, and it helps risk management tools to measure and manage a portfolio's exposure to interest rate risk and loss of expectation.read more problems seen in the case of hedging strategies. One of its applications is the delta hedge strategy, which seeks a reduction of gamma in order to hedge over a wider price range. However, the reduction of gamma results in a reduction of alpha too.

Further, the delta of an option is useful for a shorter time period, while gamma helps a trader over a longer horizon as the underlying price changes. It is to be noted that the value of gamma approaches zero as the option goes either deeper into the money or deeper out of the money. The gamma of an option is the highest when the price is at the money. All long positionsLong PositionsLong position denotes buying of a stock, currency or commodity in the hope that the future price will get higher from the present price. The security can be bought in the cash market or in the derivative market. The course of action suggests that the investor or the trader is expecting an upward movement of the stock from is prevailing levels.read more have a positive gamma, while all the short options have negative gamma.

You can download this Gamma Function Formula Excel Template from here – Gamma Function Formula Excel Template

Recommended Articles

This has been a guide to Gamma of an Option and its definition. Here we discuss Gamma Formula in Finance along with calculation and examples in excel and downloadable excel template. You can learn more about financing from the following articles –

Reader Interactions

Leave a Reply

Your email address will not be published. Required fields are marked *