A gamma squeeze is an investing phenomenon that can lead to significant gains and losses. Like most investing terms, a gamma squeeze is one few investor might be familiar with. But understanding the basics behind the gamma squeeze is essential to understanding how to use it when trading options and contracts.
Investing in the stock market is anything but a simple activity. Stock market investing requires pol of knowledge and research and proper strategy implementation. From all the concepts investors come across, a gamma squeeze can lead to significant gains or losses, depending on how investors manage it.
This article will guide an investor to the phenomenon known as the gamma squeeze. We will explain what a gamma squeeze is, how it works, and how investors can use it to their advantage on the stock market.
What Is A Gamma Squeeze?
A gamma squeeze is a market event that occurs when many investors purchase options contracts on a particular stock. The sudden and rapid shift of the stock causes a surge in demand for the underlying shares. As a result, the stock price goes up.
This creates an event where even more investors buy options contracts. However, the more investors buy these contracts; the further the stock price rises. Additionally, this creates a feedback loop that can skyrocket the stock price. Fortunately, this event lasts a short period (from a few hours to several days).
Understanding the Basics of A Gamma Squeeze
You’ll need to understand a few additional terms before understanding the basics of a gamma squeeze. A gamma squeeze is often associated with options trading. Therefore, we first must understand what options are.
Options are contracts that allow investors the right to buy or sell a particular stock at a predetermined price. In addition, investors are not obliged to do so. The predetermined price is called a “strike price.” Investors must also familiarize themselves with two types of options contracts: call options and put options. A call option allows investors the right to buy a stock at the strike price. On the other hand, a put option allows investors the right to sell a stock at the strike price.
Several factors influence the price of an option. The most influential factors are the price of the underlying stock, the time until expiration, and the stock’s implied volatility. Implied volatility measures the stock’s expected price movement over the option’s life.
When the implied volatility of a stock is high, the price of options contracts tends to be high as well, as investors are willing to pay more to have the right to buy or sell the stock at a specific price.
Another essential term to understand is the “delta.” A delta is a ratio representing a number, often called a hedge ratio. Market makers use this number to determine the number of shares they need to hedge to cover a short position.
The delta can be a big problem for market makers, especially when investors buy large numbers of shares (usually in the hundreds of thousands). The reason why the delta is a problem for market makers is down to one simple reason – they have to constantly hedge by buying more shares to cope with the constant rise of the stock’s price.
Therefore, a gamma squeeze is something they want to avoid coming across.
When Does A Gamma Squeeze Occur?
Since market makers look to avoid gamma squeezes, it begs the question, how does one even occur? A gamma squeeze often occurs after a short squeeze. The constant buying of shorted stocks results in a sudden surge in price. The market conditions for a gamma squeeze can create a worst-case scenario for market makers, and one of the most popular gamma squeezes was the GME gamma squeeze.
The GME Gamma Squeeze Explained
The 2021 GME (GameStop) gamma squeeze is one of the most well-known examples in history. It was a bizarre event where a group of Redditors from the Wall Street Bets subreddit noticed a large shorting of the stock by big hedge funds. These hedge funds were essentially betting on the price of GameStop going down. So what did these rookie investors do? They bought GME call options. As a result, the price of GME skyrocketed, contrary to the prediction of many of these hedge funds, which bet on the price to plummet.
As the demand for the GME shared increased, the stock price also increased, triggering more investors to buy call options. As you can imagine, this created a loop that further drove the stock price. This feedback loop continued for several days, causing the stock price to increase from around $20 per share to well over $480 per share.
As a result, rookie investors with call options on the stock during this time made significant profits, while hedge fund investors with put options or short positions on the stock suffered substantial losses.
How Does A Gamma Squeeze Work?
For a gamma squeeze to work, there must be a substantial interest in purchasing call options for a particular stock. The interest creates a surge in demand for the underlying shares. Again, for a gamma squeeze to work, there must be substantial demand for call options (usually in the hundreds of thousands). The demand drives the stock price up, increasing the value of the call options.
As the value of the call options increases, more investors are incentivized to buy them, increasing demand for the underlying shares and creating a feedback loop. This feedback loop can create a significant price increase in the stock, leading to massive profits for investors who hold call options. However, if the gamma squeeze is not managed correctly, it can also lead to significant losses for investors holding expiring call options.
How to Make A Gamma Squeeze Work For You?
A gamma squeeze isn’t a fully-fledged investment strategy that will make money. On the contrary, a gamma squeeze can easily lose you money if done incorrectly. But there are ways to make a gamma squeeze work for you. Below are a few tips to help you make the most out of a gamma squeeze:
- Identify a stock with high implied volatility levels and potential for a gamma squeeze. You can use options trading platforms or financial news sources to identify stocks with high options trading volumes and unusual options activity.
- Determine your investment goals and risk tolerance. Options trading can be risky, so it’s important to clearly understand your goals and how much risk you are willing to take on.
- Purchase call options contracts for the identified stock.
- Monitor the options contracts and the underlying stock price. If the stock price increases, the value of your call options contracts will also increase. Subsequently, your call options contract will decrease if the price decreases.
- Set a target price at which you will sell your call options contracts to take your profits. Having a clear strategy for managing your options contracts is important to minimize your risk and maximize your profits.
- Consider diversifying your portfolio to spread your risk and avoid being overexposed to a single stock or options contract.
- Stay informed about market trends and news to stay ahead of potential gamma squeezes and make informed investment decisions.
- Consult with a financial advisor or experienced investor for professional guidance and advice.
Remember that options trading isn’t necessarily a safe bet. Quite the opposite; it can be just as risky. Therefore, research is essential to ensure a gamma squeeze works for you. But it’s just as essential to have a clear strategy for managing your options contracts and to be prepared to act quickly if a gamma squeeze occurs.
A gamma squeeze is a stock trading phenomenon that occurs when market makers who have sold call options contracts are forced to buy the underlying stock to hedge their positions.
The hedging causes a rapid increase in buying pressure and further drives up the stock price. Gamma squeezes are usually short-lived and intense, making them ideal for patient investors to profit from options trading. However, options trading is also risky. Therefore, it’s important to research the dangers of options trading, have a clear strategy for managing your options contracts, and be prepared to act quickly if a gamma squeeze occurs.
Is a Gamma Squeeze Good?
Gamma squeezes aren’t necessarily good for traders. For example, a gamma squeeze causes sudden price hikes and short-term stock turbulence, which might not be ideal for some stock traders.
Yes, gamma squeezes have happened before. The 2021 GameStop (GME) and AMC Entertainment Holdings (AMC) gamma squeezes were the most widely reported.
The difference between a short and gamma squeeze is the underlying mechanisms and effects. A short squeeze is when investors short a particular stock or options contract. A gamma squeeze is when market makers who have sold call options are forced to buy the underlying stock to hedge their positions.