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When it comes to trading in the derivatives market, feedback loops can happen where increasing prices force market makers to purchase 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 is known as a gamma squeeze. This trend on the options market has affected a number of meme stocks, but what is a gamma squeeze and how is it different from a short squeeze?

How does a gamma squeeze affect stock prices if it is primarily caused by options market makers hedging? This article looks at current examples, including how a gamma squeeze fueled the meteoric rise of meme stocks like AMC Entertainment, GameStop, and Robinhood. It also looks at how you can potentially profit from gamma squeezes by opening a trading account and honing your trading skills to take advantage of these circumstances.

What Is A Gamma Squeeze And How Does It Work?

A basic understanding of options trading is necessary to comprehend gamma squeezes. The right to purchase 100 shares of stock within a certain time frame at a specific price, or the “strike price,” is known as a “call option.”

Someone must be willing to sell the options trader or investor the 100 shares in order for the transaction to take place. This other party is typically a market maker, or a trader who works for a company, bank, or exchange and is primarily interested in making small, steady profits rather than building up a sizable speculative wager (although they may also do this).

When many people buy call options from a market maker, the market maker effectively takes on a sizable short position in the stock. They stand to lose a lot of money if the stock price increases. They begin buying the stock to hedge their short options position in order to lessen the impact of this. Ironically, this has the opposite effect they are trying to avoid, driving the stock price higher.

Gamma enters the picture here, and in order to understand gamma, we first need to comprehend delta. These two terms, collectively referred to as “Greeks,” inform options traders about how the option behaves in relation to the underlying stock.

Delta is how much the option price will move relative to a move in the underlying stock. For instance, a delta of 0.3 indicates that for every US dollar that the stock price changes, the option premium will also change by 0.3. Delta varies between 0 and 1.

The delta is close to zero when a stock is trading substantially below the strike price of a call option. Not much movement is seen in the option premium. The delta is close to 1 when a stock is trading significantly above the strike price of a call option. Both the price and the option will fluctuate for every US dollar.

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

The market maker is informed by Delta of how much hedging is required. Assume that a market maker issued and sold 1,000 call contracts (100,000 shares) with a strike price of $10 while the stock was trading at $8. In this case, the market maker is short. The stock is below the strike price and not even close to it, so the market maker is not in danger.

The market may not need to hedge at all if the delta on a position like this is 0 or 0.1, or they may choose to buy 10,000 shares as a partial hedge (delta of 0.1 x 100,000 shares). However, if the stock price increases, the delta at the strike price gets closer to 0.5. Gamma measures this modification.

To properly hedge, the market maker must continue purchasing additional shares as the stock price rises, further igniting the rally. For example, an option with a delta of 0.7 will have a 70% chance of expiring in the money. Delta can also be thought of as the likelihood that an option will expire in the money. In order to cover the 50% chance that the call will expire above the strike price and their exposure to potentially needing to deliver the shares to the call buyer, the market maker will typically have at least 0.5 of the position hedged, or 50,000 shares, when the stock is at the strike price. When the price and delta reach 1, which happens eventually, the entire options position needs to be hedged. Purchasing 100,000 shares is required.

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

Gamma Squeeze Vs. Short Squeeze

In contrast to a short squeeze, a gamma squeeze is connected to the positioning of options rather than stocks.

A short squeeze happens when the price of a stock that is heavily shorted rises sharply and the short sellers’ positions unwind, further accelerating the price of the stock. This may occur if unanticipated news has an effect on the stock price or if demand for the stock suddenly increases.

A gamma squeeze happens when there are too many options buyers in one security, which has an impact on dealer hedging and causes the underlying stock to move sharply.

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. The stock price is driven higher if the market maker has a short options position.

When a market maker sells stock to hedge an option position that is net long, the stock price is driven down. It is far less common to try to profit from this scenario than from one where the stock price is forced higher.

The hedge does not have to continue indefinitely, regardless of whether the gamma squeeze drives a stock price higher or lower. The stock price typically makes a significant move back in the opposite direction as the options expire or the hedge is no longer necessary (or reduced) due to a change in delta. Everything that rises eventually falls.

How Can I Take Advantage of Gamma Squeezes?

In retrospect, it appears simple and obvious to have purchased stocks that surged higher as a result of a gamma squeeze. Despite this, there is a lot of options trading on almost all well-known stocks, and large gamma squeezes like the ones discussed are relatively uncommon. It’s also possible that the price is simply trending higher, making the gamma squeeze less obvious. When trading shares, gamma squeezes are not always simple to identify or take advantage of.

Finding stocks that are likely to increase in value and that are also experiencing a lot of call buying, which causes market makers to enter a net short position, remains the key to profiting from a gamma squeeze. Start speculating and potentially making money off of erratic stock price movements by opening a spread betting or CFD trading account. To learn more, read our guide on how to sharpen your trading edge. It’s important to keep in mind that developing into a consistently profitable trader can require a lot of practice and persistence.

The gamma squeeze may help fuel the rally as the stock price rises, increasing the potential for gains on long positions.

To profit from a gamma squeeze, you must act quickly because the rally might end quickly. If you want to protect yourself from downside volatility and lock in some profits so that the profits are not all lost when the reversal move happens, think about using a trailing stop loss or another exit strategy. Trading a gamma squeeze successfully often requires careful risk management and protection against volatility on the downside.

Stocks are impacted by more than just gamma squeezes. This means that big moves higher in stock prices can happen even in the absence of a gamma squeeze.

Gamma Squeeze Summary

Compared to short squeezes, gamma squeezes are typically stronger and shorter-lived. Gamma squeezes are all about option contracts, whereas short squeezes center on short-sellers closing out their positions by purchasing stock. Investors will also purchase out-of-the-money call options in addition to common shares. Short sellers will then buy call options to cover their short positions in response. Both of these result in market makers having to purchase additional shares of the stock, which causes an upward surge.

Gamma squeezes on the stock market are relatively rare and typically end when the option contracts’ strike prices are reached. The two most prominent gamma squeeze incidents happened in 2021 for the meme stocks AMC and GameStop.

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