What is a gamma squeeze?
Learn how investors leverage options to create market impact and gain insights into the risks and rewards of gamma squeezes.
The gamma squeeze became famous as a trading term in 2021 when Reddit users assembled to increase the price of companies such as AMC and GameStop. A high-risk, short-term investment option, a gamma squeeze can provide happiness and horror depending on which side of the market-trading fence you are sitting on.
What is a gamma squeeze?
In the world of finance, the term “gamma squeeze” has gained considerable attention in recent years and is often linked to the phenomenon of a short squeeze. Here, we delve into the concept of a gamma squeeze, exploring its complicated mechanics and providing a well-known recent example to help you grasp its significance in the stock market.
Where does the phrase Gamma Squeeze come from?
To comprehend a gamma squeeze, we first need to understand the concept of gamma in options trading – known as the Greeks:
Gamma is a Greek letter used to measure the rate of change in an option's delta concerning changes in the underlying asset's price.
Delta, another Greek letter, indicates how much an option's price will change with a $1 move in the underlying asset.
Gamma, in essence, quantifies the speed at which delta changes. When traders buy options, they effectively control a certain amount of the underlying asset's shares per option contract. Gamma measures the acceleration or deceleration of this control as the underlying asset's price moves.
How does a gamma squeeze work?
A gamma squeeze occurs when a surge in the underlying asset's price forces market makers and option sellers to adjust their positions rapidly. As the price rises, the options they sell start to accumulate gamma, which can lead to a cascade effect.
Gamma squeezes are often short-term and accompanied by extreme price volatility, making them highly unpredictable and risky. This investment is not for those looking for reliable or consistent returns.
Retail traders and social media platforms, such as Reddit, for example, often play a significant role in initiating gamma squeezes.
What causes a gamma squeeze?
A gamma squeeze is primarily caused by the dynamics of options trading and the relationship between options market participants, particularly between retail traders and market makers.
Here are the key factors that contribute to a gamma squeeze:
High options activity
A gamma squeeze typically begins with a surge in trading activity in options contracts, particularly call options. Call options give traders the right to buy an underlying asset at a specified price within a certain timeframe.
A significant concentration of call options, often driven by retail traders or coordinated groups, plays a crucial role. When many traders purchase these call options, it can create a substantial demand for the underlying asset.
Market makers and short gamma
Market makers are entities that facilitate options trading by providing liquidity. They sell options contracts to traders. Market makers engage in delta hedging to manage their risk, which involves buying or selling the underlying asset based on the options' delta. When market makers sell call options, they are effectively short gamma, meaning they need to buy the underlying asset as the price rises to hedge their exposure.
Gamma feedback loop
The rate of change in delta, known as gamma, accelerates as the underlying asset's price moves. When the underlying asset's price rises, the gamma of call options increases, forcing market makers to buy more shares to hedge their short gamma positions. This buying activity triggers a feedback loop, further boosting the asset's price.
Short squeeze potential
If the underlying asset also has a high level of short interest (many investors have bet against it), the gamma squeeze can interact with a short squeeze. As the price rises due to the gamma squeeze, short sellers may be forced to cover their positions by buying back shares, adding even more upward pressure on the asset's price.
Gamma squeezes often occur as options approach their expiration dates. As options get closer to expiry, the rate at which market makers adjust their positions accelerates, intensifying the gamma feedback loop.
What are good examples of a gamma squeeze?
A classic example of a gamma squeeze can be seen in the GameStop (GME) stock, when retail investors, led by the Reddit forum WallStreetBets, bought up shares of GME and call options. As GME's price increased rapidly, market makers who had sold those call options had to buy shares of GME to hedge their exposure. This, in turn, drove up the stock's price even further, creating a feedback loop of buying pressure – a classic gamma squeeze.
The AMC gamma squeeze was another notable market event in 2021, following a similar pattern to the GameStop saga. Retail investors, many from the same Reddit forum, WallStreetBets, purchased a significant number of call options on AMC Entertainment Holdings (AMC) stock. As the price of AMC surged, market makers who had sold these options were compelled to buy AMC shares to hedge their exposure, leading to a rapid increase in the stock's price.
This gamma squeeze in AMC exemplified the influence of retail traders and the dynamics of options trading, causing heightened market volatility and sparking conversations about market dynamics and regulation.
What are the repercussions of a gamma squeeze?
Gamma squeezes can have a broader impact on the market, affecting the specific stock involved and related assets. In the case of GME, other heavily shorted stocks experienced increased volatility as traders sought similar opportunities.
The bottom line
A gamma squeeze is a fascinating phenomenon in the world of finance, driven by the intricacies of options trading and the dynamics between market traders and market makers.
It's a reminder that financial markets are not just about numbers and equations but are also influenced by human behavior and sentiment. As demonstrated in the GME example, a well-coordinated set of actions by a large group has the potential to influence the market.
For this reason, understanding gamma squeezes is crucial for investors and traders looking to navigate the complexities of today's stock market landscape.
Financial advisors understand this complexity. They make it their business to keep up to date with the latest movements in financial markets. Unbiased can match you with the right advisor for your financial goals – or even help to set financial aims and objectives. Find yours now.
Senior Content Writer
Rachel is a Senior Content Writer at Unbiased. She has nearly a decade of experience writing and producing content across a range of different sectors.