Gamma hedging is a risk management strategy used by options traders to neutralize or minimize the impact of changes in the gamma of their options positions. Gamma measures the rate of change of an option’s delta concerning changes in the price of the underlying asset. Since delta itself represents the sensitivity of an option’s price to changes in the underlying asset’s price, gamma hedging aims to offset or balance the delta changes that may occur.

Here’s how gamma hedging works:

1. **Understanding Gamma and Delta:**

– Gamma measures how fast delta changes. Delta, on the other hand, represents the sensitivity of an option’s price to changes in the underlying asset’s price.

2. **Recognizing the Need for Gamma Hedging:**

– Options traders may use gamma hedging to manage the risk associated with changes in delta. This is particularly important for market makers, professional traders, and others who want to maintain a delta-neutral or delta-balanced position.

3. **Delta-Neutral Positions:**

– A delta-neutral position is one in which the sum of positive deltas is offset by the sum of negative deltas, resulting in a net delta of zero. Delta-neutral strategies aim to reduce directional risk and focus on other factors such as volatility or time decay.

4. **Adjusting Delta with Gamma Hedging:**

– As the underlying asset’s price changes, the delta of an options position may change. Traders can use gamma hedging to adjust their position, buying or selling the underlying asset to offset changes in delta and maintain a delta-neutral position.

5. **Regular Rebalancing:**

– Gamma hedging involves regularly rebalancing the options position to keep the overall delta close to zero. This may involve buying or selling shares of the underlying asset to offset changes in delta resulting from price movements.

6. **Challenges of Gamma Hedging:**

– Gamma hedging can incur transaction costs, especially when frequent adjustments are needed. It requires active monitoring and quick responses to market changes.

7. **Volatility Impact:**

– Changes in volatility can also impact gamma and delta. Traders need to account for the impact of volatility changes when implementing gamma hedging strategies.

8. **Risk Management:**

– Gamma hedging is a risk management tool that aims to reduce exposure to market movements. It is not a guarantee against losses but is used to manage and control risk associated with changes in delta.

Gamma hedging is commonly used by options market makers and other sophisticated traders who actively manage their options portfolios. It requires a good understanding of options pricing, the Greek letters (gamma, delta, theta, vega), and the dynamics of the underlying asset’s price movements. Traders often use sophisticated software and models to assist in the monitoring and execution of gamma hedging strategies.