Trading in derivatives (things like options and futures) involves juggling a lot of relatively obscure price-related concepts. These are collectively known as The Greeks. Not because they live on Mt. Olympus, or...for other reasons. But because they are designated by a Greek letter.
One of these concepts is called gamma. But to talk about gamma, first we need to give an overview of another Greek: delta. Delta measures how much the price of a derivative changes when the price of the underlying asset changes.
You purchase an option to buy 100 shares of MSFT at $120, with an expiration two months from now. MSFT's stock rises by $1. How much does the value of your option change? Answering that question will give you delta.
Okay, onto gamma. Gamma lets you know how much the delta for an option changes when the price of the underlying asset changes.
MSFT's price rises $1. How much did the price of your option change? That question gives you delta. How much did the delta change? That question gives you gamma.
So gamma is dependant on delta. It's called a second-derivative measure. As you can tell by now, calculating these things can take some serious math. Even the pricing of the options themselves can get complicated due to the multiple facets involved.
Here's where the gamma pricing model comes in. It represents an alternative way to compute the price of an option.
The most common way to perform the task is called Black-Scholes. It works most of the time, but falls short in certain situations. Specifically, Black-Scholes doesn't do a good job with options where the price movement on the underlying asset deviates from normal distribution.
The math of the gamma pricing model is pretty involved, so we aren't going to list any equations here. The basic premise, though, goes like this: it uses gamma to derive the option's price.
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Finance: What are Theta and Theta Decay?10 Views
finance a la shmoop what are they two and theta decay well in Wall Street
parlance theta is just time you know parsley sage rosemary and our nevermind [Parsley, sage and rosemary plants appear]
okay this is time like with a calendar the tea there in theta
it stands for time or tick-tock and in this case theta refers to the amount of
time left on a contract as that contract gets closer to expiring or executing [Timeline of contract expiration date]
well you'd say that the theta decays like a molding old skeleton returning [Decayed skeleton appears in grave]
ashes to ashes dust to dust so yeah when theta decays the amount of
time left on a contract a trade the life of a stock option lessons most commonly
theta decay is applied to the time remaining on stock option contracts
well what theta is it yep example theta all right so let's say you paid five
bucks a share for a call option to buy Comcast shares for 40 bucks a share [Call option for comcast appears]
anytime in the next four and a half months the stock trades today at $34 a
share well if the stock were still at thirty four bucks a share four months [Calendar months fall off the wall]
later ie with only two weeks or a ten trading days left well what would you
guess your call option to buy Comcast at forty bucks a share or six dollars above
where it's currently trading would be worth more than five bucks less you know
way less for that option to be worth anything positive the stock would have
to go above forty or appreciate seventeen and a half percent ish in ten
days and nobody would then pay an incremental five bucks above that figure [Cash thrown onto a fire]
to then buy the shares for an all-in cost of forty five bucks trying to make
money like the stock would have to zoom from 34 to fifty bucks a share to really [Man holding comcast stock]
have a good outcome risk adjusted so as the option got closer to expiring its [Call option moves to expiration date]
value would decay because the optionality got less there's less time
for that stock to break fifty bucks and change if there were a thousand trading
days in the future and the option had notionally like five years before it
expired like enormous theta well then it would likely have sold for
vastly more than five bucks a share you know for that stock option and hey if [Piles of cash appear on table]
you want to see real decay well just check out Simon and Garfunkel lately
looks like they're you know homeward bound [Man discussing Simon and Garfunkel]
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