When stock prices change drastically, the environment could be favorable for a squeeze. In this case, stockholders can find themselves purchasing or selling outside of their usual trading routine in order to limit losses. An extreme case of this is a “gamma squeeze,” in which investor buying activity drives a stock’s price up, frequently fairly dramatically. Find more information about gamma squeeze and how gamma squeeze works in this article.
What Is a Gamma Squeeze in the Stock Market?
Gamma Squeeze is a characteristic of the derivatives markets because it is a component of trading in options. Gamma squeeze serves the purpose of assisting makers who have sold call options on a certain stock to hed their exposure to negative (short) gamma and negative (short) delta.
The price of the underlying shares rises as market participants buy or sell out of their positions. Gamma squeeze is the term for this.
- The term “delta” refers to the anticipated change in an option’s price in response to a $1 change in the value of the underlying stock. Because the option’s price would increase in tandem with an increase in stock price (delta), a positive delta denotes a long position in the market, while a negative delta denotes a short position.
- Gamma, which simply refers to the rate of change of the delta, is the first derivative of the delta. Its values are highest for options that are ATM (at the money), and lowest for those that are distant OTM or ITM (in the money).
Widespread speculation about the potential direction of a stock’s price can lead to a gamma squeeze. In addition, a number of significant donors to the phenomenon include:
- Short-dated call options on a stock
- Delta hedging
- Shares with low liquidity
What Is a Gamma Squeeze vs Short Squeeze? The Differences
A short squeeze is comparable to a gamma squeeze. A gamma squeeze, in contrast to a short squeeze, is initiated by the market maker rather than a trader.
The major reasons for a gamma squeeze are unpredictable price movements and excessive trading volumes that compel market makers to close out their holdings. The gamma squeeze will likely result in a large quantity of trade, which could raise the price.
For instance, you might have good ratings on Gamestop. The stock is trading at $30 when you decide to buy $50 calls that expire in a month. You are being sold the possibilities that you choose. Frequently, the party on the other side of the transaction is a market maker.
Market makers loathe assuming a lot of risk by providing several options. They will purchase common stock shares to safeguard their positions.
An option’s delta calculates how much its value varies in reaction to changes in the underlying stock. If the delta of a call option is 0.30, the option will increase by 30 cents for every dollar that the stock increases.
If the market maker sells an “out of the money” call and the stock increases, they will need to buy more shares to cover their position. The market maker will increase the number of shares it buys as the gamma increases.
The market maker will have to purchase an increasing number of shares if the stock rises to $600, $700, $800, $900, and eventually $1,000 if you purchase a $1,000 put option on Tesla when the stock is trading at $500. Gamma squeeze is this.
Similar to a gamma squeeze, a short squeeze affects traders rather than market makers. Similar situations where there is a sharp market movement brought on by high trade volume in a certain direction can result in traders being forced out of their positions.
I borrow part of your stock and sell it right away. I have to give you back these shares.
Consider that I borrowed your $75,000 collector Corvette. I predicted that the supply of Corvettes would be much more than previously imagined, which led me to believe that the price of the car would decrease. You made the decision to charge me $2,500 a month in exchange for letting me use the car.
I take the automobile to the neighborhood dealer and sell it for $75,000 there.
The cost of the vehicle is reduced to $50,000 six months later. I return the car for $50,000 and deliver the keys to your home. I end up keeping $10,000 in profit after paying your $15,000 rental cost ($2,500 x 6).
So what happens if the Corvette’s price continues to increase? Since I have to return the automobile to you, I might start to panic and try to buy it back at a loss. When I visit the dealership, the price is $95,000 because there is more demand. I choose to wait.
It turns out that many other people sold the loaned car in the same way I did, hoping to profit from the decline in value. All of these car short-sellers are now seeking to repurchase the car in addition to the genuinely increased demand for it.
This results in a brief squeeze.
Gamma squeezes: How Do They Operate in Stock Trading?
Gamma squeeze can cause spikes and clips in the stock price while the squeeze takes place. This squeeze frequently corrects itself, although it might provide traders short-term trouble.
Following some significant company-related news that leads the markets to behave irrationally in either way, a gamma squeeze frequently occurs. This behavior leads to extreme short-term volatility, which causes the squeeze to happen.
The GameStop stock drama that occurred at the beginning of this year is the ideal illustration of a gamma squeeze. The stock price of the video game retailer rose by more than 400% at one point. Demand for GME call options increased in tandem with the growth in interest in GME, prompting option sellers to hedge their risk by purchasing shares of the stock, which led to an increase in price.
During the GME squeeze, some investors made significant returns, while others suffered severe losses.
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How Long Does a Gamma Squeeze Last?
It’s crucial to schedule your investments properly because a gamma squeeze can persist for days, weeks, or even longer. The last thing you want is to experience a gamma squeeze when you are forced to purchase high and sell cheap.
It’s also not a straight line; both AMC and GameStop had significant price surges followed by sharp price declines. This left a lot of investors holding the short end of the stick, but it has occurred before.
In fact, institutional investors frequently utilize the short squeeze and gamma squeeze to compete with one another, and there have been numerous well-known short squeezes throughout the history of Wall Street. The current squeeze is not the largest ever.
What Happens During a Gamma Squeeze?
A gamma squeeze happens, as mentioned when stock prices rise and force investors to adjust their stock positions. The squeeze can occur when there is a significant increase in the buying of short-dated call options on a single company, which causes a sharp price increase. This may prompt investors to purchase further calls, driving up stock prices even further.
The short squeeze, which happens when a rise in stock price drives investors who have shorted the stock to purchase back those shares, is one of the most well-known squeezes. Short-sellers wager on a decrease in the price of a stock for a short squeeze to happen.
Gamma squeeze can present an exceptional opportunity to traders and investors, but there is a high degree of danger. Since the gamma squeeze can lead stock values to plummet significantly when they move in the other way, timing is crucial in this situation.
Example of Gamma Squeeze
The GameStop (GME) spectacle, which recently garnered headlines after a spectacular increase in its share price over a relatively short period of time. Investors require a counterparty in order to buy call options on the GME. On the other side of the trade, the market maker (counterparty) typically adopts this position.
Market makers typically don’t care about changes in the price of the underlying stock because they make money on the deal itself (spread). Therefore, should the price of the underlying stock increase, adding more long calls entails risk for the market maker. Market makers visit the market and buy the relevant stake in order to protect themselves from such unfavorable fluctuations.
In the end, this is what led to the rapid rise in the price of the GME share. Theoretically, this event was a result of both a short squeeze and a gamma squeeze, with the latter adding fuel to the fire.
How to Spot a Gamma Squeeze
Only unusual events often result in a gamma squeeze. Usually, it’s because a wealthy individual or group wants to take over a business, but in the case of Reddit’s surge, they were seeking stocks that were highly shorted.
The monthly statistics on shorted stock options can be used to identify stocks with an excessive number of shorts relative to the number of outstanding shares. Then, in order to find the finest short-squeeze candidates, they organize themselves on online forums, keep track of these maneuvers, and watch the Greeks.
Of fact, not every short squeeze results in a gamma squeeze. It happens at random times. Even though both AMC and GME had the same audience focused on them, AMC took longer to reach the Gamma squeeze.
The Bottom Line
Beyond gamma squeezes, other factors can have an impact on stocks. This suggests that significant increases higher in stock prices can happen without a gamma squeeze and that strong moves higher won’t always follow a gamma squeeze.