This question of why we track gamma and not delta comes up fairly often. (For those needed a level one primer on delta vs gamma go here: OptionsPlaybook. If you need a primer on options market makers check here.) Our belief is that when options market makers (MM’s) start and end each day delta neutral. Most trades that MM’s make go right into their book where the risk is offset or adjusted with all of their other positions. Very large trades have risk that needs to be addressed immediately. This means that the delta hedge would probably be traded right away, offsetting the directional risk from that large trade. Essentially – we don’t think MM’s take large delta (directional) risk. Obviously the market is constantly moving, so they need to constantly address the risk in their portfolio. This is where gamma comes into play.
If the MM’s were essentially delta neutral when the market is at 3125 then their portfolio will be off with the market at 3140. This means they will have to adjust their hedges to be delta neutral again. The amount they need to trade to make this adjustment is their gamma.
We try to estimate this gamma – just how much the MM’s need to buy or sell for a given move in the market. If we have an estimate of how much these MM’s need to trade we can compare that to expected market volume and form estimates of how much we expect the market to move. Said another way we can try and forecast volatility.
The total delta is somewhat irrelevant because we assume that market makers are delta neutral (or close to it) at the start of each day. We care about what they are going to do in the future and the impact that will have.
