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What is a gamma squeeze and how does it affect stock prices?

When it comes to trading in the derivatives market, feedback loops can occur where rising prices force markets makers to buy stock in order to cover their options exposure, which in-turn pushes up prices further, causing even more buying from market makers to cover their positions and so on and so forth, creating what’s known a gamma squeeze. Several meme stocks have been affected by this options market phenomenon, but what is a gamma squeeze and how is it different from a short squeeze?

While a gamma squeeze is largely due to hedging by options market makers, how does it affect stock prices? This article explores recent examples, such as how a gamma squeeze fuelled a meteoric rise in meme stocks like AMC Entertainment, GameStop and Robinhood, as well as how to potentially take advantage of gamma squeezes by registering for a trading account and honing your trading skill to capitalise on these situations.

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What is a gamma squeeze and how does it work?

To understand a gamma squeeze, a bit of options trading knowledge is required. A call option is the right to buy 100 shares of stock at a given price, called the strike price, within a given amount of time.

When an options trader or investor buys a call option, someone needs to be on the other side of the transaction and be willing to sell them the 100 shares. This other party is usually a market maker – traders who work for an exchange, bank or company and are mainly looking for small steady profits rather than accumulating a massive speculative bet (although they may do this as well).

When many people buy call options from a market maker, the market maker is effectively taking on a large short position in the stock. If the price of the stock rises, they face large losses. To mitigate this, they start buying the stock to hedge their short options position. This ironically has the effect of pushing the stock price up – the very thing they don’t want.

This is where gamma comes in, and to understand gamma, we need to understand delta. These terms are both known as ‘Greeks’, and they tell options traders how the option acts relative to the underlying stock.

Delta is how much the option price will move relative to a move in the underlying stock. For example, a delta of 0.3 means for each US dollar the stock price moves, the option premium will change by 0.3. Delta fluctuates from 0 to 1.

When a stock is trading well below a call option’s strike price, then the delta is near 0. The option premium doesn’t move much. When a stock is trading well above a call option’s strike price then the delta is near 1. For each US dollar the price moves, so will the option.

Gamma is the change in delta for each dollar the stock price moves.

Delta tells the market maker how much they need to hedge. Assume a market maker is short by issuing and selling 1,000 call contracts (100,000 shares) at a strike price of $10 and the stock is currently trading at $8. There is no danger to the market maker because the stock is below the strike price, and not even near it.

The delta may be 0 or 0.1 on a position like this, meaning the market doesn’t need to hedge at all, or they buy 10,000 shares as a partial hedge (delta of 0.1 x 100,000 shares). But if the stock price rises, delta approaches 0.5 at the strike price. Gamma measures this change.

As the stock price rises the market maker must keep buying more stock, further fuelling the rally, to adequately hedge. Delta can also be seen as the probability of an option expiring in the money, so for example, an option with a delta of 0.7 will have a 70% chance of expiring in the money. When the stock is at the strike price the market maker will usually have at least 0.5 of the position hedged, or 50,000 shares in order to cover off the 50% probability that the call will expire above the strike price and their exposure to potentially needing to deliver the shares to the call buyer. As the price keeps rising, so does delta, eventually reaching 1, which means the whole options position must be hedged. That means buying 100,000 shares.

Imagine this on large scale – millions of shares – where a market maker is forced to keep buying as the price rises, adding to the rally with their own buying because they need to hedge a position that could lose a lot of money if the price rises. That is what’s called a gamma squeeze.

What have been some major gamma squeezes in the past?

AMC Entertainment and GameStop are two examples of US stocks that experienced significant gamma squeezes.

In the case of AMC Entertainment and GameStop, both stocks were already being accumulated and hyped by WallStreetBets, a large group of retail traders in the popular discussion forum Reddit. Along with stock buying, hundreds of thousands of call options were purchased by retail investors, with the market makers on the other side of the trade.

As the prices of each stock rose, it created a gamma squeeze where the market makers were forced to buy the stocks and push both stocks prices up even more. It formed a vicious feedback loop, which resulted in GameStop jumping more than 2,000% in a couple weeks, and AMC Entertainment rallying close to 800%. The rally was also fuelled by hype, and not the gamma squeeze alone. The gamma squeeze helped to push the price up.

These examples can also be classified as a short squeeze​​ because there were large short positions in the stocks themselves.

Robinhood’s stock also experienced a gamma squeeze. Like the run-up in AMC Entertainment and GameStop, Robinhood became a ‘meme stock​​’ with a lot of retail interest around it. Once again, this buying interest in the stock, coupled with large call option purchases, meant market makers were also forced to buy into an already escalating rally.

At the time in early August 2021, Robinhood had recently completed its IPO. Options on Robinhood commenced trading the day before a 50% stock price jump and gamma squeeze, resulting from the mass number of options that were purchased in the first two days of options trading.

One of the biggest examples of a gamma squeeze was when SoftBank, a Japanese technology investment company, earned the moniker “Nasdaq whale” after it bought billions of dollars’ worth of US equity derivatives in the technology sector in 2020. It had been buying massive amounts of call options on indices​ and ETFs​ as well as individual stocks like Tesla, Amazon, Alphabet and Microsoft, which stoked a feverish rally in tech stocks.

Are gamma squeezes a double-edged sword?

Gamma squeezes are sometimes referred to as a “double-edged sword” as they can propel prices in either direction. If the market maker has a short options position, then the price of the stock is pushed higher.

If the market maker has a net long options position, then they sell the stock to hedge, and the stock price is pushed lower. Trying to capitalise on this scenario is far less popular than where the stock price is squeezed higher.

Whether the gamma squeeze pushes a stock price up or down, the hedge does not need to last forever. As the options expire, or the hedge is no longer needed (or reduced) because delta changes, the stock price typically has a hard move back in the other direction. What goes up, comes back down.

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How can I take advantage of gamma squeezes?

In hindsight, it looks easy and obvious to have jumped on stocks that exploded higher because of a gamma squeeze. Yet nearly all well-known stocks have a large amount of options trading, and large gamma squeezes like the ones discussed are quite rare. Or the gamma squeeze is less obvious because the price may just trend higher steadily. Gamma squeezes are not always easy to spot or capitalise on when share trading.

Taking advantage of a gamma squeeze still comes down to figuring out which stocks are likely to rise and that also have a large amount of call buying, which puts market makers into a net short position. Open a CFD trading account to start speculating and potentially profit from volatile stock price movements. It’s worth keeping in mind that becoming a consistently profitable trader can take a lot of practice and perseverance.

As the stock price rises, the gamma squeeze could help exacerbate the rally, which could lead to bigger profits on a long position.

A swift exit is a vital component to successfully capitalising on a gamma squeeze as the rally may not last long. Consider using a trailing stop loss​ or some other exit method that protects you from downside volatility and locks in some profit, so the profits are not all given back when the reversal move occurs. Managing your risk​ and guarding against downside volatility can also be a vital component to successfully trading a gamma squeeze.

Stocks are affected by multiple factors, not just gamma squeezes. That means a gamma squeeze won’t always result in a big move higher in stock prices, and big moves higher can occur without a gamma squeeze.