INVESTING EXPLAINED: What you need to know about Gamma

In this series, we bust the jargon and explain a popular investing term or theme. Here it’s Gamma.

Something from a sci-fi novel?

Nothing so exciting. But this options market metric, which takes its name from the third letter of the Greek alphabet and is an indicator of share price volatility, has been appearing more frequently in stock market reports. This reflects concerns that Wall Street’s unexpected bounce this year – the S&P 500 index is up by 18 per cent since January – could be running out of steam.

An increase in volatility is often a sign that confidence in the outlook for share prices is waning, as investors turn fearful.

This is why some analysts at major banks and brokers are looking very closely at the gamma positions of option traders.

Remind me. What are options?

Options are financial derivatives. You buy a ‘call’ option if you want to acquire the right to buy a certain share at a fixed price at some point in the future. If you want to sell that share, you buy a ‘put’ option.

Options trading, an activity with huge risks, has doubled since 2020, with 10billion contracts in the US alone last year.

This was partly the result of the greater involvement of private investors, which began during the pandemic. But many are now participating less, having either made losses – or found the jargon, including terms such as gamma, incomprehensible.

What is the significance of gamma in options trading?

Gamma is one of the ‘option Greeks’. These are the metrics used by traders to gauge the factors that may influence an option’s value – and so discover whether they are going to make or lose money on the contract. The key metrics are delta, gamma, theta and vega.

Delta is an estimate of how much an option’s value may change given a move of £1 or $1 either up or down in the value of the underlying share. The gamma shows the rate of change between an option’s delta and the price of the underlying share.

The theta should show by how much the value of an option should decline as the expiry date approaches, while the vega should give a picture of the influence of large ups and downs in the price of that underlying share.

These calculations are carried out by computers rather than humans.

This is still all Greek to me…

It is less important to understand the mathematics behind the calculations of gamma than to be aware of the role that this and other metrics are playing, behind the scenes, in the direction of stock markets.

Some Wall Street analysts even use their estimates of the gamma exposure of the option traders as a basis of share recommendations. If these traders believe that they are about to lose money on a contract, they will buy the underlying share, which may drive up its price. This phenomenon is called a ‘gamma squeeze’.

In 2021, a fund manager at a division of Morgan Stanley concluded that gamma estimates suggested that stocks would hold steady and did a series of lucrative deals based on that assumption, earning this individual the nickname the Gamma Hammer. It all suggests that options trading is a highly complex matter. You may conclude it’s best left to the professionals.