You may have heard of a so-called short squeeze. In this scenario, an increasing stock price forces market participants who were shorting the stock to buy it back, which in turn drives the stock price higher. A gamma squeeze is similar. But it represents a more complex type of short squeeze, as it’s typically an interaction between purchased options, stocks that are heavily shorted, and the market makers.
Differences Between Gamma Squeeze And Short Squeeze
The difference between a short squeeze and a gamma squeeze is that a gamma squeeze is caused by too many options being bought. In a short squeeze, it doesn’t happen through options but through high demand for a stock. Hence, a gamma squeeze is an extended form of a short squeeze. The order is not necessary, but it depends on the situation. It is often the case that both events occur at the same time. In this situation, the squeeze has a considerable impact.
Gamma Squeeze In Detail
As mentioned, it is not specified which squeeze occurs first. Therefore, the example in this article explains the scenario when a gamma squeeze occurs first, which leads to a short squeeze.
Too many options are being bought: Call options are typically purchased by private investors to profit from them. They do it because they speculate that a stock’s price will skyrocket. Institutional investors also buy options. But as opposed to private traders, they usually buy put options to protect themselves against declining stock prices. Of course, they also are buying call options, but these amounts are really limited, and they usually cannot trigger a gamma squeeze.
Market makers hedge themselves with stocks. This pushes a stock’s price higher: This is the main reason a gamma squeeze is triggered in the first place. What is usually not very well known is that when someone buys options, they are also sold by brokers. The reason brokers sell options is that most of them take on the role of market makers to create liquidity in the market.
But on the other hand, this is, at the same time, a problem for brokers. Because by selling options, the broker enters into a commitment to sell a share at some price once things start to go wrong. But to be able to sell a stock, a broker must own it first. To own a stock, he must get the stock on the stock exchange. And the more call options private traders buy, the more shares a broker has to purchase to hedge, driving the stock’s price higher.
Short sellers must close positions. This also pushes the price upwards: If it is a stock with a high proportion of short float, the high demand from market makers puts the short sellers under pressure. The short sellers suddenly have to close their positions, often at the best possible price, to limit losses. This, in turn, creates additional demand on the market and leads to even higher stock prices. And what started with a gamma squeeze turns now into a short squeeze.
Another scenario when a short squeeze transitions to a gamma squeeze you will find below in the example with the GameStop squeeze in 2021.
Why Is It Called Gamma Squeeze?
Gamma is one of 4 metrics in options trading (Delta, Gamma, Vega, Theta). The following explanation may be difficult to understand for someone unfamiliar with options trading. If you are interested in serious options trading, I can recommend this online course about options trading*. There you will also learn about these 4 key metrics in detail, and you will see that they are pretty easy to understand.
But before we delve into gamma, we need to understand the role of the delta. Delta tells you how much an option’s price will change if the stock price changes by $1. Gamma tells how much the delta changes when the stock changes in price by $1.
And gamma is the metric brokers observe when market participants buy options. Because of the gamma, they know how many shares they need to buy to hedge against losses. This method is also called “be delta neutral”. Here’s a quick example to make it easier to understand:
Example:
If the market maker has sold an option with a delta of 0.2, then he will buy 20 shares to become delta neutral.
The gamma in our example is 0.08.
Now the price of the stock increases by $1. How much does the delta change?
To calculate this, we just need to add delta and gamma together: 0.2+0.08=0.28.
This means that if the delta increases from 0.2 to 0.28, the broker needs to buy another 8 shares to become delta neutral.
If the delta continues to increase, the broker has to buy new shares, which fuels the demand. In our example, the broker only sold one option. But what if he would sell 100.000 options with a delta of 0.2? How many stocks would he need to buy to become delta neutral?
It’s 100K shares x 0.2 delta x leverage of 100 (because each option always involves 100 shares.)
Result: 2.000.000 shares the broker would have to buy. And that amount of stocks can already start to influence a stock’s price.
Two Gamma Squeezes Based On Real Examples
GameStop
The last most infamous gamma squeeze happened in 2021 during the GameStop hype, or how I call it: GameStop fever. What exactly happened? Here’s the rough timeline:
Since GameStop’s business model got into trouble, numerous hedge funds started to bet on the further decline of GameStop shares by shorting the stock.
But in 2019, Keith Gill started investing in GameStop stock. He initially bought 50 shares and continued to buy more stocks up to a total investment of around $53.000. While doing this, he spent months posting screenshots of his GameStock positions to a subreddit r/wallstreetbets. And with this, a discussion started in the forum. This caused investors who had plenty of cash to jump on the bandwagon and start buying shares in GameStop.
In August 2020, Investor Ryan Cohen also bought shares and gradually increased his stake from 9% to 12.9% by December 2020. In total, he invested around $76 million through his company RC Ventures LLC.
On October 7, 2020, hedge fund Senvest Management LLC acquired 5.54% of all available GameStop shares.
But despite these purchases, the company’s stock remained strongly shorted and available in the market at a low price.
However, members of r/wallstreetbets jumped into the stock, influenced by actions from Gill and former investors. This increasing demand and increase in price persuaded other private investors to get in.
At some point, the short float of all publicly traded GameStop stocks was up to 140%. So it was a vantage point to sound the charge on the hedge funds on Reddit, in which the participants motivated each other to buy more shares but also call options. This initially triggered a monstrous short squeeze. In addition, the many call options they bought forced the brokers to buy GameStop shares as well. Hence, the initial short squeeze triggered a gamma squeeze and pushed GameStop stock to highs of $325. In premarket trading, the price reached levels above $500, from around $17.
Lehman Brothers
Most people are familiar with a gamma squeeze in connection with a sharp increase in a stock’s price. But there can also be a gamma squeeze on the downside. This is called a negative gamma squeeze or reverse gamma squeeze. We saw an example of such an event in the collapse of Lehman Brothers.
In the case of Lehman Brothers, more and more traders and investors purchased put options to hedge against the drop in the Lehman Brothers stock price. A purchased put gives the buyer the right to sell a stock at a specified price. Those who sold the puts committed to buying the stock at a specific price.
And in such scenario a broker is also a market maker, doing delta hedging. But in the case of a negative gamma squeeze, they don’t buy stocks, but they sell their shares to balance the risk. The more of a stock they sell, the more supply exceeds demand, and that leads to what? Right, to an accelerated price drop!
Is It Possible To Trade Gamma Squeezes?
A gamma squeeze is a rare event that usually occurs with cheaper and illiquid stocks. In addition, it is a very rapid ongoing associated with high risk. Because in addition to the pressure to buy, a gamma squeeze can also cause strong pressure to sell. As the gamma is derived from the delta, it has its highest value at the option’s strike price. If the stock price moves too far away from the strike price, the gamma value will reduce, and the pressure to hedge will decrease accordingly. This, in turn, usually reverses the previous effect. An initial buying pressure quickly converts to selling pressure.
As gamma squeeze is a quick event, it’s very difficult catching the right stock at the right moment. Most of the time, the squeeze will be over before most market participants would know about it. There’s a company called Fintel trying to use a computational model to show the likelihood of stocks that tend to be susceptible to a gamma squeeze. The system is currently in a test phase, and it remains to be seen how it will develop.
Hence, there is still no easy way to get rich quickly, and every successful trader has to work for his fortune. Bad luck…
Subscribe for free to receive new posts and support my work. The subscription will be proceeded via substack.com. There, you can subscribe for free content but also for premium content. Just check it out by clicking the button below! If you would like to publish content on substack, please click here.
SUBSCRIBE TO A NEWSLETTER*Affiliate link: when you click on this link, no additional costs would arise for you and the product or the service will not become more expensive. When you decide to buy the product or use the service, I’ll get a little benefit from the provider which I would reinvest to keep this blog alive.
