What is Gamma Squeeze

A squeeze in finance is a rapid and sudden change in the prices of an underlying asset that prompts investors to change their investing actions that they would not have otherwise had to do. When there is such a rapid change in prices, there will be investors who will feel ‘squeezed’ and have to take action to prevent being ‘choked’ in the market. A gamma squeeze is an example of this scenario and is associated with the options trading market. It happens when options market makers seek to cover or hedge their exposure, and their activity can lead to higher stock prices in the equities market.

Gamma Squeeze Explained

To understand gamma squeeze, it is imperative to know about options trading, specifically call options and delta.

Call options are derivative contracts that give investors the right to buy an agreed amount of an asset at a specified price (strike price) by a specific date. Call options earn investors profits if the underlying stock price is above the strike price by expiry. An option contract is typically made with a market maker who provides liquidity and is willing to buy or sell different contracts to profit from the premium or transaction costs.

When many investors buy call options, it essentially means that the market maker is placing a substantial short position on the underlying asset. This exposes the market makers to massive risk if an upward directional move happens and many investors’ contracts expire in the money.

The risk is even higher for the market makers because options are leveraged products. Market makers will buy the underlying stock to hedge against their short position to counter this risk. This buying activity serves as another tailwind for the underlying stock, pushing prices higher and higher. This sets the stage for a gamma squeeze.

But to further understand the squeeze, it is vital to understand the terms’ delta’ and ‘gamma’. These ‘Greeks’ usually help understand an option contract’s risks. Delta shows how much the price of an option contract is expected to change when the underlying stock or security price changes by $1 (or one pip in the case of FX pairs). Call options have positive delta values from 0 to 1. Delta determines whether an option contract is likely to expire in the money.

Out-of-the-money options will have a delta closer to 0, and at-the-money options will have a delta close to 0.5, whereas deep-in-the-money options will have a delta close to 1. The higher the delta, the wider the price change. A delta of 0.4 means that the option premium will change by $0.4 for every $1 change in the underlying stock price.

On the other hand, gamma is the rate at which an option’s delta changes. Gamma is at the highest for at-the-money options, progressively decreasing as delta approaches 0 or 1.

A gamma squeeze then happens when the underlying asset price rises rapidly within a short period. This forces market makers to cover their positions, leading to a significant market spike. A gamma squeeze illustrates how activity in the options market can influence volatility in the equities market.

Gamma Squeeze vs Short Squeeze

Gamma squeeze is a scenario similar to a short squeeze, but the difference lies in whom the impact is on. A gamma squeeze is when stock prices rise, and option market makers are forced to exit their short positions. On the other hand, a short squeeze impacts a trader who went short in the equities market and is forced to exit the position. In both scenarios, though, a sharp rise in prices forces either the market maker or trader to alter their investment plans in the market.

Recent Gamma Squeeze Examples

Here are some recent examples of a gamma squeeze in the markets:

AMC Entertainment

AMC Entertainment is an American theatre exhibition company that has faced negative fundamentals recently. Its business was significantly hindered further during the 2020 COVID-19 pandemic when populations were kept indoors. In January 2021, the AMC stock traded as low as $2, with the company speculated to go bankrupt.

But an investing group on a popular social platform, Reddit, rallied investors to ‘punish’ big hedge funds that seek to profit from companies experiencing tough times. Alongside buys in the stock market, investors also purchased multiple call options, with market makers taking the opposite trade. At the height of the gamma squeeze in June 2021, AMC traded as high as $62. After the gamma squeeze, however, prices quickly collapsed to normal levels.

GameStop

Like AMC, GameStop (a video game and entertainment merchandise retailer) faced increasing short pressure after speculating that its 2020 performance was abysmal. Its stock traded below $20 before the turn of the year, and many traders and two large hedge funds were reportedly shorting it.

However, Reddit investors aggressively bought the stock and accumulated extensive call options that simultaneously caused both a short squeeze and a gamma squeeze. By the end of January 2021, GameStop stock traded as high as $340 but quickly tumbled below $50 before the end of February 2021.

SoftBank

In August 2020, SoftBank (a Japanese tech conglomerate) bought out the money options of US technology companies such as Salesforce, Apple, Tesla, Alphabet, and Amazon. The company’s actions triggered a gamma squeeze in the markets that caused several stocks of the underlying tech companies to post unprecedented price gains within a short time (in August alone). For instance, Salesforce stock jumped over 26%, Tesla stock rallied over 74%, whereas Apple shot over 21%.

Final Words

Gamma squeezes are unique market phenomena that can create lucrative opportunities for traders. Investors, however, need to trade them with careful timing because they also pose significant risks. AvaTrade provides a stable and advanced trading platform for trading gamma squeezes efficiently. Browse the AvaTrade education section and learn more about taking advantage of gamma squeezes in the market.

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FAQ

  • What is a Gamma Squeeze?

    A gamma squeeze happens when stock prices rapidly rise in the market. This triggers buying call options in large volumes, forcing market makers to cover their positions by buying the underlying stock. This can lead to a significant spike in the stock price.

  • How Long Does a Gamma Squeeze Last?

    This depends on how many outstanding options the market maker needs to hedge against. Typically, a short squeeze lasts just a few days, but in extreme cases, it can go on for a few weeks.

** Disclaimer –While due research has been undertaken to compile the above content, it remains an informational and educational piece only. None of the content provided constitutes any form of investment advice.