Gamma is the rate of change of delta of an option, in response to changes in the prices of an underlying asset. It gives us a significant evaluation of convexity of a future contract’s value, with respect to the underlying assets.
Points to remember:
A positive gamma depicts an affirmative convexity of trading position.
In order to preserve a hedge over a wide price range, a delta hedge plan involves reducing gamma. However, a major outcome of reducing it is that, alpha too, is reduced.
Example: Let us assume that a call option on an underlying stock has a delta of 0.4. If the value of that stock goes up by $1, the option’s value increases by $0.40, inevitably changing its delta to 0.53. The 0.13 difference in deltas is measured as an estimated gamma value.