Gamma Squeeze: How It Works and Should You Trade It?

What Is a Gamma Squeeze?

A gamma squeeze occurs in the options market when market makers' hedging activities lead to a rapid increase in the price of a stock.

Hedging means taking a position in one market to offset potential losses in another, reducing overall risk.

Additionally, “market makers” are financial intermediaries that facilitate trading by buying and selling securities from their own accounts to provide liquidity and stabilize prices in the market.

To understand how a gamma squeeze occurs, it is essential to delve into the basics of options trading and the role of the Greeks in trading.

Options Trading

Options trading is a financial practice where contracts, known as options, give the buyer the right, but not the obligation, to buy (call option) or sell (put option) an asset at a specified price before a certain date.

For example, an investor might buy a call option for Company X's stock at a strike price of $50, paying a premium for the right to purchase the stock at that price within a specified time frame.

If the stock's price rises to $60, the investor can exercise the option to buy at $50, thus potentially profiting from the increase. There are multiple option strategies that help traders make profitable trades.

Options contracts are crucial for understanding a gamma squeeze because they create the conditions under which market makers must hedge their positions.

The Greeks in Trading

The "Greeks" are essential risk measures used in options trading to describe different dimensions of risk involved in taking an options position. Key Greeks include Delta, Gamma, Theta, and Vega:

• Delta measures the rate of change of the option's price with respect to the change in the underlying asset's price.

• Gamma measures the rate of change in Delta for a one-point move in the underlying asset's price. It indicates how much the Delta will change as the underlying stock price changes.

How Gamma Squeeze Works

The interplay between options trading and the Greeks—particularly Gamma—explains how a gamma squeeze unfolds.

As traders buy more call options, the market makers increase their hedging activities by purchasing the underlying stock. This buying pressure causes the stock price to rise, which in turn increases the Delta of the options.

Since Gamma measures the rate of change in Delta, a high Gamma indicates that Delta is increasing rapidly, requiring market makers to buy even more stock to stay hedged.

This cycle can lead to a significant and rapid increase in the stock price, illustrating how a gamma squeeze operates in the market.

Types of Trading Squeezes

Trading squeezes occur when stock prices rapidly move due to traders rushing to cover their positions. There are different types of squeezes, including short squeezes, bear squeezes, and gamma squeezes.

Gamma Squeeze vs Short Squeeze

A gamma squeeze is often compared to a short squeeze. While both involve rapid price movements, they occur due to different reasons. A short squeeze happens when short sellers rush to buy back shares to cover their positions, driving the price up.

In contrast, a gamma squeeze involves market makers buying shares to hedge their positions in response to changes in options trading. Therefore, one is caused by traders, and the other is caused by market makers.

Gamma Squeeze vs Bear Squeeze

A bear squeeze is another type of trading squeeze but is different from a gamma squeeze. It occurs when investors, anticipating a decline in stock prices, face a sudden price increase, forcing them to buy back the stock at higher prices.

What Causes a Gamma Squeeze

A gamma squeeze can be triggered by several factors that interact to create significant upward pressure on a stock's price.

Key elements include:

High Open Interest in Call Options: When there is a large number of outstanding call options for a particular stock, it indicates that many traders are betting on the stock's price to rise.

This high open interest can set the stage for a gamma squeeze as market makers need to hedge their positions.

Rapid Changes in Stock Prices: Sudden and significant stock price movements can amplify the effects of a gamma squeeze.

As the stock price rises quickly, the Delta of the call options also increases, prompting market makers to buy more of the underlying stock to maintain their hedges.

Market Makers' Hedging Activities: Market makers, who provide liquidity by buying and selling options, hedge to manage their risk. When traders buy call options, market makers sell these options and then buy the underlying stock to hedge their exposure.

This hedging activity can drive the stock price higher, contributing to the gamma squeeze.

How Long Does a Gamma Squeeze Last?

The duration of a gamma squeeze can vary depending on the persistence of the conditions that cause it. Generally, a gamma squeeze continues as long as there is:

• High Demand for Call Options: As long as traders keep buying call options, market makers will continue to hedge by purchasing the underlying stock, sustaining the upward pressure on the stock price.

• Significant Hedging Activities: The squeeze will last as long as market makers need to adjust their positions to stay hedged. Once the buying pressure from hedging decreases, the impact of the gamma squeeze typically diminishes.

However, a gamma squeeze is usually temporary. Once the demand for call options stabilizes or decreases, and the market makers' hedging activities reduce, the price surge often subsides.

The exact duration can range from a few days to several weeks, depending on market dynamics and investor behavior.

Gamma Squeeze Real-Life Examples: AMC and GameStop

The phenomena of gamma squeezes became widely recognized during the unprecedented stock market events involving AMC Entertainment Holdings Inc. (AMC) and GameStop Corp. (GME) in early 2021.

AMC Entertainment Holdings Inc.

In the case of AMC, a gamma squeeze contributed to its extraordinary price surge. Retail investors, particularly those on forums like Reddit’s r/WallStreetBets, started buying large amounts of call options for AMC.

This created a significant open interest, indicating that many traders were betting on AMC’s stock price to rise. As more call options were purchased, AMC’s stock price began to rise.

The initial upward movement in the stock price was partly fueled by the increased demand from retail investors buying shares in addition to call options.

Market makers who sold these call options needed to hedge their exposure to potential losses, so they bought shares of AMC to offset their risk.

Source: Google Finance

This led to a self-reinforcing cycle, with the rising stock price forcing market makers to buy more shares, further driving up the price. This cycle intensified the upward momentum, resulting in a substantial increase in AMC’s stock price over a short period in 2021.

As you can see in the chart above by Google Finance, AMC's stock price reached an all-time high of $261.44 on 18 June 2021, then dropped again to now reach $5.46.

GameStop Corp. (GME)

A similar scenario unfolded with GameStop but on an even more dramatic scale. In January 2021, GameStop's stock experienced an unprecedented surge, primarily driven by a gamma squeeze fueled by retail investors and social media hype.

The initial catalyst for GameStop's gamma squeeze was a significant amount of call options being purchased by retail investors. As GameStop’s stock price began to rise, these call options increased in value.

Market makers, needing to hedge their exposure, started buying shares of GameStop to manage their risk. This hedging activity contributed to the stock's upward momentum.

As the stock price soared, more call options moved into the money, necessitating additional hedging by market makers.

This created a powerful feedback loop: the rising stock price led to further buying pressure from market makers, pushing the stock price even higher. Short sellers, who were forced to cover their positions, further intensified the situation, adding to the buying frenzy.

Source: Google Finance

Within days, GameStop's stock price skyrocketed from $20 to an all-time high of $86.88, as you can see in the chart above by Google Finance.

Both AMC and GameStop are prime examples of how gamma squeezes can lead to extraordinary stock market price movements. They were major events in the trading industry, inspiring the creation of one of the best stock market movies, Dumb Money.

Gamma Squeeze Strategy: Trading Gamma Squeeze

Trading a gamma squeeze can be highly profitable but comes with significant risks due to market volatility.

To approach this strategy effectively:

1. Identify stocks with high open interest in call options, rising prices, and active retail investor interest.

2. Monitor market conditions for increased buying activity and rapid price changes as signs of an impending gamma squeeze.

3. Execute trades by buying call options or the underlying stock and use stop-loss orders to protect against sudden drops.

4. Hedge your positions with strategies like purchasing put options to manage risk and balance your portfolio.

5. Stay informed about financial news, market trends, and social media discussions related to your target stocks for timely decision-making.

Finally, monitor the stock's behavior and market signals to determine the best time to take profits and exit positions, as gamma squeezes can end abruptly, leading to sharp declines.

Final Verdict: Should You Trade the Gamma Squeeze?

Whether you should trade a gamma squeeze depends on your risk tolerance, market knowledge, and trading strategy. Due to rapid price increases, gamma squeezes can offer substantial profits, but they also come with high volatility and significant risk.

Therefore, only consider the gamma squeeze strategy if you have a solid understanding of options trading, the mechanics of gamma squeezes, and effective risk management strategies.