Question

1. In your own words (ie., do not cut and paste an answer), explain what the gamma of an option reflects and why it is related to risk.

Answer 1

Gamma of an Option measures how fast the delta changes for small changes in the underlying stock price. i.e. the delta of the delta.

If we are hedging a portfolio using the delta-hedge technique, then we have to keep gamma as small as possible, the smaller it is the less often we are required to adjust the hedge to maintain a delta neutral position. If gamma is too large, a small change in stock price could wreck our hedge. Adjusting gamma, however, can be tricky and is generally done using options.

Note: Delta is the degree to which an option price will move given a small change in the underlying stock price.