Color

Color is an options "greek" that measures the rate at which gamma will change over time. More specifically, it is the third order derivative of an options value - once to time and twice to the option's price. Other options greeks include delta, gamma and vega, which are used in options pricing models.

Also known as gamma decay or the derivative of gamma with respect to time (dgamma/dt)

Options greeks measure many characteristics of options pricing, from how fast the options price changes with respect to the price changes in the underlying asset, called delta, and the rate of decay of the option's time value, called theta.

Gamma, itself, measures the rate of change in an option's delta per 1-point move in the underlying asset's price. Delta is the first derivative or price, gamma the second and color, the third. Color is an important trait to monitor when maintaining a gamma-hedged portfolio because it helps the trader to gauge the effectiveness of the hedge over the passage of time.

Gamma is also used when trying to gauge the price movement of an option, relative to the amount it is in or out of the money. When the option being measured is deep in or out of the money, gamma is small. When the option is near or at the money, gamma is at its largest. Gamma calculations are most accurate for small changes in the price of the underlying asset. All options that are a long position have a positive gamma, while all short options have a negative gamma.

Traders who use a gamma-hedging options trading strategy use color to capture information on the gamma of an option per year (the daily figure can be found by dividing the result by the number of days in the year). Color is a fairly accurate measurement when the option is far from expiration. However, as expiration draws near, color becomes more volatile, even intraday, and less accurate.

As options move closer to expiration, their prices become more in line with directional price moves. Gamma, for example, will move higher, which can reduce the efficacy of hedging strategies. Therefore, color is important to follow to know just how much those hedging strategies become less effective.

Borrowing from physics, if delta is the velocity of options price movement with respect to the underlying, then gamma is the acceleration. Since the third derivative is a bit hard for non-scientists to grasp, we can move these greeks down one level. Now consider gamma to be the velocity of delta and therefore color is the acceleration of gamma.

Basically, gamma expands as expiration draws near and color measure it. However, color also expands, creating a domino effect. That is why it is imperative to monitor it to be sure hedges still work.