Gamma
It's All Greek to Me
While its small size makes the Greek economy of small interest to most global investors, most of them would be lost without a working command of certain Greek phrases: alpha (a synonym for risk-adjusted excess return), beta (an asset's sensitivity to broad market movements), and the less widely used delta (the sensitivity of an option's price to changes in the price of the asset underlying it). Even less widely used but of no small importance is the letter that preceeds delta in the Greek alphabet (truly): gamma. Oversimplifying, gamma is a measure of how an option's delta changes in response to changes in the underlying asset's price. An option's delta tends to be stable for small changes in the price of the underlying asset but wildly unstable for truly big price moves.
Relevance for Some Readers
With US stock valuations near historic highs, an increasing number of investors are using options-based strategies to reduce potential losses should stock prices slump. Taxable investors prefer hedging over outright selling because the former permits them to defer capital gains taxes; and many "pros" prefer hedging (i.e., buying puts) over outright selling because it keeps them "in the game" if stock prices continue to rise. From a technical standpoint, the quasi-bearish sentiment reflected in hedging activity is bullish: it means peak enthusiasm for US stocks is not truly universal. But viewed in a different light � with a "gamma ray" if you will � hedging is potentially very harmful to the market. It's harmful because, as the saying goes, "for every buyer there must be a seller" and vice versa. While sophisticated systems enable put sellers to construct delta-neutral portfolios, put sellers as a group cannot hedge to any reliable or meaningful degree gamma-induced systemic shocks. As noted in a seminal study by London-based Smithers & Co., if US stocks move sharply lower in a "lumpy" (as opposed to gradual) manner, the deep-pocketed parties who'd hoped to profit modestly from delta-hedged put writing could suffer intolerably large losses. The reason: it's very hard to rebalance positions as needed (i.e., to remain delta-hedged) when prices move a lot in a short time period.
Relevance for Most Readers
Mindful that most readers do not play around with options (nor do we, typically), we think the foregoing discussion of gamma is germane nonetheless, albeit by analogy rather than directly. It's germane because many non-profit organizations pursue investment policies founded on so-called efficient frontier analysis, a statistics-based approach to asset allocation that presupposes periodic rebalancing of portfolio positions to preordained norms. Unfortunately, many of the assets that make "efficient" portfolios "efficient" to begin with are impossible to trade with the periodicity assumed by most efficient frontier studies. Examples include real estate, venture capital, certain absolute return-oriented strategies, and even certain "marketable" but often-illiquid emerging market stocks. This doesn't mean that such "efficient" portfolios will necessarily plummet in value should gamma-related problems rear their ugly head in the US stock market, but it does mean that hoped-for benefits from holding uncorrelated assets may fail to materialize � at precisely the time when such benefits are needed the most. [*]
Endnote
* Just to be clear, the reason gamma is "relevant" for most members by analogy only is because conventional portfolios do not have "gammas" � only options do.