Gamma scaling is an adjustment mechanism used in options trading to manage the gamma exposure of a portfolio, particularly when market volatility changes or when a trader seeks to maintain a neutral gamma position. It involves dynamically altering the size of underlying asset hedges based on prevailing market conditions and options sensitivities. This technique is critical for precise risk management in crypto options markets.
Mechanism
Gamma measures the rate of change of an option’s delta with respect to the underlying asset’s price. When gamma is large, delta changes rapidly, requiring frequent adjustments to the underlying hedge to maintain delta neutrality. Gamma scaling involves a systematic approach to increase or decrease the hedging size, the amount of the underlying asset bought or sold, as the market moves, in anticipation of these delta changes. This is often based on models that account for current volatility, time to expiration, and strike price.
Methodology
Traders employing gamma scaling continuously monitor the portfolio’s gamma and the market’s realized and implied volatility. Automated systems execute fractional adjustments to the delta hedge, for instance, reducing the size of the underlying position if gamma is high and expected volatility is low, or increasing it if gamma is low and volatility is high. This disciplined approach aims to optimize hedging costs, mitigate the risks associated with rapid price swings, and capitalize on movements in the volatility surface within crypto options markets.
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