Gamma Pricing Model

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.