July 20th, 2004, 1:03 pm
Here is a quick and dirty answer. Gamma is, among other things, a measure of how a delta hedge will slip if the underlying changes. Hedge slippage for a delta hedger can be either a good or bad thing, depending on whether you are short or long. Suppose you have bought an option and are delta hedging it. Every hedge readjustment will generate a positive P/L effect. Hence the buyer of delta-hedged options will generally want realized volatility to be greater than the purchase implied volatility, so the larger the gamma the “better”. If you have sold a delta-hedged option, every hedge readjustment will generate a negative P/L effect, so in this case large gamma is “undesirable”. This is why option traders generally face negative gamma limits only.