Delta-Gamma Hedging

Sounds like a wild frat ritual, but far from it. In fact, it has to do with playing it safe in the realm of options trading.

First things first: In options trading, delta refers to the ratio that compares the change in the price of the underlying security to the change in the price of its corresponding derivative. So if an option has a delta of 0.40, when the underlying stock price increases by $1 per share, the value of the option will increase by 40 cents a share.

Now for gamma. Gamma is the rate of change of the delta itself. So if a long call option has a gamma of 0.10 and a delta of 0.40 and the underlying stock increases by $1 per share, the delta will now be 0.50.

With delta hedging, a trader protects herself from small price movements in the underlying stock by offsetting with either a long or a short position. But a large price change will also cause a big change to the delta. So by adding a gamma hedging strategy, the trader can effectively prevent the delta from moving.

Yep. It's all Greek to everyone but options traders.