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Option gamma: identifying levels of pain

Published in Automated Trader Magazine Issue 39 Q2 2016

The increasing popularity of shorter expiry S&P 500 options has the potential to significantly impact the underlying market. Analyzing the hedging pressure of market makers can help to identify critical points.

Stefan Wintner


Stefan Wintner, CFA, is a managing partner and head of volatility strategies at Systematic Absolute Return AG. His focus is on forecasting volatility and volatility-of-volatility, managing a systematic volatility trading strategy and designing tail risk management tools. He holds an MBA from Vienna University of Economics and Business Administration and is a CFA and FRM charterholder.

Ever since Black and Scholes introduced their famous option pricing formula, traders have been sensible about hedging their exposure to the various risk measures (price of the underlying, time till expiration, volatility, interest rates, dividends). Arguably, the most important exposure an option has is to the price movements of the underlying instrument. This sensitivity is labelled delta. Delta-hedging is a term familiar to every option trader. The importance of options with relatively short maturities - as defined by the trading volume and levels of open interest - has increased. Therefore, the risk in option trading nowadays is not just defined by the option delta. The importance of the option gamma, which measures the sensitivity of the option delta to changes of the underlying price, can create large delta exposures even on smaller moves in the price of the underlying and thus creates volatility spikes. This article shows how to use option gamma to identify 'pain levels' of the market.

Recap of option delta and gamma

The concept of option delta (Δ) is quite simple. Ex post, one would compare the change of the price of an option (V) with the price change of the underlying instrument (S). So how many dollars does the price of the option change if the price of the underlying changed by some dollar amount:

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