A gamma squeeze is a temporary price anomaly that stems from a rapid rise in a stock price. When this happens more and more speculators will trade call options, forcing those who sold those calls to buy some stock to hedge the calls sold. This has a significant impact on the underlying price of the stock.
Gamma squeezes can directly impact the price of a security. Exhibiting rapid price movements accompanied by a sharp increase in volatility. Some of the most recent examples of gamma squeezes are Gamestop and Tesla stocks.
What is a gamma squeeze?
Squeeze is a common term used in the financial markets. They represent periods of rapid price movements and extreme volatility. There are different types of squeezes, but the mechanics of it are somewhat similar. When several traders or investors take the same size of a trade, the trade becomes crowded. With so many market participants expecting a certain price movement, this creates a feedback loop that propels security prices in a certain direction. Although squeezes tend to be momentary and last just a couple of days they can extend into weeks.
A gamma squeeze forces additional stock buying activity due to open option positions on the underlying stock. When a stock starts moving upwards, investors and traders tend to buy more call options. Institutional investors or other traders selling those calls will need to hedge those positions, and therefore they buy the underlying stock. A gamma squeeze, therefore, represents a more complex squeeze type, as it results from the options pricing model.
Gamma of an option
One of the most important concepts in the trading of options is the ratios known in technical language as Greeks (options greeks). Options Greeks come from individual derivations of the Black-Scholes formula.
The Greeks are used to express the sensitivities of the option price to the individual value drivers. One of these Greeks is the gamma. This metric is often used by market makers to figure out how to design their hedge. The gamma corresponds to the second partial derivative of the option price after the price of the underlying or the first partial derivative after the delta.
Accordingly, the ratio indicates how the delta changes in relation to a changing price of the underlying security. Consequently, the gamma measures how high the change in the delta is if the price of the underlying increases by one monetary unit. Gamma represents the indirect sensitivity of the underlying security price as a value driver.
Connection with gamma squeeze
The higher the gamma, the larger the equity position the market maker needs to effectively hedge against the open option positions. As a result, when gamma changes, market makers are forced to buy or sell the underlying stock to make their hedge effective. A large number of such forced buy or sell activities eventually cause a gamma squeeze.
Gamma squeeze explained
Gamma squeezes can cause swings and dips in the stock price while the squeeze is occurring. Often this squeeze corrects itself, but it can cause extreme short-term volatility. A gamma squeeze often follows a major news story about a company that causes the markets to move unpredictably in one direction or another. This behavior leads to extreme short-term volatility that triggers the squeeze.
Gamma squeeze examples
GME gamma squeeze
At the beginning of 2021, Gamestop (GME) was one of the most shorted stocks in the market. So much so that there were more shares short than shares outstanding. With the majority of investors expecting the company to file for insolvency. Shorting GME became one of the most common trades for both institutional and retail investors.
Due to the risk of a short squeeze, institutional investors, in particular, do not simply sell the stock short. They also hedge their short position by buying opposite and out-of-the-money calls (i.e., the strike price of the calls is higher than the current share price). Suppose an investor sold short 100 GameStop shares at $10 per share in October 2020. Then this investor could have simultaneously bought a call option with a strike price of, say, USD 15 to hedge the short position at a relatively low price.
GME short squeeze turns into a gamma squeeze
In January 2021, the short squeeze in GameStop stock was in full swing. The fundamental situation of the company had not changed. However, thanks to the short squeeze, the share price has multiplied. Consequently, the higher share price attracts even more short sellers, as this has significantly increased the profit potential on the short side.
These new short sellers, in turn, buy more out-of-the-money call options to hedge against a further rise in the share price. In addition, more and more speculators became active, betting on a further rapid rise in the share price and accordingly buying call options that were also way out of the money. Their hope was that these options, which could be purchased cheaply, would ultimately be listed in the money and could be sold again giving them an incredible return.
Ironically, this very behavior forces market makers to buy more and more shares for the effective hedging of their short positions. In turn, this causes the stock price to continue to rise. When the stock price finally approaches the strike price of the options, the market makers are forced to buy significantly more shares again to hedge the gamma accordingly. This subsequently leads to the gamma squeeze.
Tesla gamma squeeze
Another example of a gamma squeeze is Tesla. The stock reached more than $1,200. This makes the company worth more than a trillion dollars. Making it larger than the 14 largest automakers in the world combined.
Tesla’s market cap is a product of speculators, and a gamma squeeze. Operationally, the company’s market share of the auto industry is still incredibly small. The total number of vehicle deliveries is still not even comparable with other legacy automakers.
What drove Tesla’s share price?
First of all, it is clear that many investors are clearly buying the stock after the positive news, namely the order from Hertz. There are also some market participants trying to profit with call options. But there is probably another, and arguably more important reason for the explosion in Tesla stock: and that is the gamma squeeze.
The sharply rising price forces those who had speculated on falling prices by shorting the stock to cover their short position. Those who had speculated on falling prices now have to buy back the (previously sold) share. In order to limit their losses. The volume of call options on Tesla stock during that week was also unprecedented.
In the week that led up to the increase to its all-time high, the volume of Tesla call options traded was a staggering amount. Especially when compared with the major options traded during the same period. The number of call options traded also contributed to the rapid rise of the stock price, creating a gamma squeeze.
How to trade a gamma squeeze?
To trade gamma squeezes, you must have a high-risk tolerance. Because of the complexity of each situation, gamma squeezes are never the same. Some show up with very sharp spikes and price changes, while others subside over weeks.
The most important key to trading a gamma squeeze is timing. Because of the speed at which a gamma squeeze unfolds, a trader who cannot recognize and act on the situation quickly enough will suffer losses. The extreme volatility is also difficult to manage for some traders.
There are two factors of a gamma squeeze that you should look out for:
- High short interest: For a squeeze to occur, traders need to get stuck. The most common type of trader to get stuck in a persistent short trader. Short squeezes may also be followed by a gamma squeeze.
- Options activity: options are another important component of a gamma squeeze. Paying attention to volumes of options traded, and the direction of the market can give traders and investors edges into possible gamma squeezes forming.
Be cautious with gamma squeeze
As a final note, it is worth mentioning that a gamma squeeze should be viewed with extreme caution. Due to the extreme volatility, and unpredictability associated with it, it’s sometimes difficult to trade. In addition to buying pressure, a gamma squeeze can also create strong selling pressure. Since gamma is derived from delta, gamma has the steepest slope at the option strike price. Thus, if the stock price moves too far away from the strike price (regardless of the direction), the gamma reduces and, correspondingly, the pressure to hedge also reduces.
This in turn usually leads to the reversal of the previous effect. An initial buying pressure thus quickly converts to selling pressure. Regardless of what the driver for any reversal is, a gamma squeeze is a temporary phenomenon.
Image source: Bloomberg