When I am working with option mentoring students, for the most part they can figure out At-The-Money options. They get that as the every strike becomes more ATM that the delta change from 50 delta to the next strike in either direction has decreased because of volatility. But what about out of the money options? Do out of the money options lose gamma, or gain with an increase in IV. The answer is both!
For options that are well out of the money, in general any increase in implied volatility is going to increase gamma. This is very significant for condor and strangle traders to understand. They need to know that initially, when the IV increases on their condor, the condor is going to have more delta sensitivity in a downturn than the model predicts. Take a look, here is a MNX condor with strikes that are 10% out of the money.
Now we raise IV 5%. Notice that in fact the position does get shorter gamma, and for most traders this is all they will need to know.
However, the crazy thing with OTM options rears its head if we increase IV significantly, in this case 15%. Notice then that the gamma actually FALLS!!!
Why does this happen? When IV increases OTM options go through a progression. As IV increases, at first OTM gain gamma as they become more like an ATM option (remember ATM options have the most gamma). Once these options gain enough IV that they actually BECOME ATM options then they begin losing gamma with increases in volatility.
While this can seem confusing think about it this way. Out of the money options gain gamma increases in volatility, until they are not longer out of the money options.
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