One of the real misconceptions I have seen out of retail traders is volatility. Many do not realize that it actually affects every part of the Greeks. Remember, the Greeks are not real, they are the equivalent of a weather forecast, except probably less reliable. The one that seems to get people the most confused it gamma. When IV falls gamma increases. The reason, as I explain it, is that when a stock has a lower vol, each move it makes has more certainty to it. For instance,
BP, a high vol stock is trading 40.00 and I am long an August 40 call. If the stock rallies from 40 to 41 how much delta will the 40 call gain? Not very much, thus it has low gamma
EXC, a low vol stock is trading 40, and I am long an August 40 call. If the stock rallies from 40 to 41 how much delta will the 40 call gain. Much more, because that 1 dollar move has a lot of certainty.
There are other ways to explain it as well, but I think Lance, one of my students summed it up best once I was done:
"For ATM options, when the expected price movement as reflected in implied volatility declines the significance of a given price movement increases"
I could not have said that better myself, gamma represents the significance of price movement. If a stock is really whippy, how significant are its price movements? In the case of a stock like AMZN, not very. If a stock barely moves and then drops 2 dollars (like P&G today) how significant is the price movement? Very.
That is the best I can do on gamma in 300 words or less. If this is something that you are not used to hearing, check us out. Sign up for the free pit report every morning at 9:50 AM EDT. Heck, contact me (888) Trade-01 or mark@optionpit.com
