Gamma Squeeze: How Does It Drastically Affect Stock Prices

What is Gamma Squeeze?

Gamma squeezes are common in the derivatives market as part of options trading. These derivatives' prices are continuously determined to display 'gamma' through a series of mathematical calculations. Gamma is at the highest level when the derivative price is very close to the actual share price. When a trader chooses a sells and buy option, the market maker must supply the asset for the required charges when redeeming the option. Market makers often take significant positions to counteract these large risks.

As a result of the traders buying and selling at high volumes, the market makers may need to buy or sell their positions, leading to a large volume of trades in the market; as a result of the market makers' purchases or sales, the price of the underlying shares surges. Gamma squeezes are often associated with options trading. Option trading differs from stock trading in some ways. You're most likely trading with a market maker when you open an options contract and not with a private investor.

Market makers are primarily concerned with profiting from trades. For pricing options contracts, the Black Scholes model is typically used. It is actually based on the option-pricing model they'll operate with you. In addition, market makers will likely hedge their positions either by buying or by shorting the stock. Gamma squeezes are created by hedging. During a Gamma squeeze, stock prices soar, and investors are forced to adjust their positions in the stock market. In a reduction, many short-dated call options of an individual stock are purchased, resulting in a dramatic price increase. Investors may be tempted to buy more calls, resulting in even higher stock prices.

Short squeezes are popular, as rising stock prices force short sellers to buy back their positions, resulting in higher stock prices. For a quick reduction to occur, short-sellers must bet that a stock's price will decline. Despite their potential, gamma squeezes can pose a significant amount of risk to investors and traders. As a result, timing is critical because the gamma squeeze can cause stock prices to fall dramatically when they move in the opposite direction.

What causes Gamma Squeeze?

Gamma squeezes are caused by large volume trades in one direction in a short time. This will lead to a significant share price spike as the market maker has to close out their positions. World news and trader sentiment heavily influence the market. Trade volumes can increase when big news breaks in a particular direction. High market volumes can benefit traders, but they can often result in market makers being forced out of positions.

A large volume of shares being bought or sold puts further pressure on the share price when buying or selling the underlying asset. Although market makers try to hold on and mitigate risk wherever possible, it's not always possible in a fast-paced, volatile environment.

What Is the Duration of a Gamma Squeeze?

Gamma squeezes can last for days or even weeks, depending on what are causing them. Considering that gamma squeezes are not sustainable over the long run, timing is crucial, as prices can rise rapidly within a short period, and price reversals can also occur quickly. Whenever stock prices reverse, the move in the opposite direction can result in massive losses.

Gamma squeezes occur when market makers must buy more shares of the underlying stock as more call options are purchased. Short sellers fall off due to this, and the Gamma rises to a large number, as happened in Reddit's and Discord's short squeeze.

How a Gamma does Squeezes work?

The market conditions must be met before a gamma squeeze can occur. Typically, investors bet on the rise of a specific stock's price. Short-term call options are massively purchased as a result.

Institutional investors will end up selling call options in a short position when they buy many call options for the underlying stock. In situations where investors continue to buy call options, institutional investors might have to invest more money into the store to ensure that they have very little or no net exposure to the stock.

You must have a high-risk tolerance to trade gamma squeezes. Gamma squeezes are complex, and there is no one-size-fits-all solution. Several of them will show themselves in sharp price changes and peaks, while others will wane over time.

To trade a gamma squeeze, timing is vital. Gamma squeezes unfold at a rapid pace, so traders who can't identify and act upon the situation in time will lose out. It is also vital to have an excellent platform that responds quickly.

You should look out for two factors that suggest a gamma squeeze:

• High short-stock interest: Traders who become stuck are necessary for a squeeze to take place. Traders who get stuck most often are stubborn shorts

• Options activity: Another crucial component of a gamma squeeze is options. The fewer market makers move, the less gamma squeeze there is. The consequence is that fewer positions can be squeezed.

Gamma squeeze trading steps

1. Creating an account or logging in

2. Market research is essential before you trade

3. Analyze the situation yourself

4. Manage your risk by taking steps

5. Your position should be opened, monitored, and closed

The GameStop stock saga early this year is an excellent example of a gamma squeeze. An analysis of the company's stock price shows a rise of more than 400% at one point. Due to the growing interest in GME, the demand for GME call options increased as well, forcing option sellers to hedge their risks by purchasing GME shares, driving prices higher.

During the GME squeeze, some investors made handsome profits, while others suffered steep losses.

How Gamma Squeezes drive up AMC’s stock price

Part of AMC's rally was driven by heavy equity options trading. Depending on the stock price, these financial derivatives allow buyers to purchase or sell shares at a fixed price in the future. During regular trading, the value of these derivatives fluctuates by the changing probability of the buyer exercising that right.

Traders can capture these changes with a variety of mathematical calculations, including. Market makers who sell options could ultimately have to deliver the underlying stock, so they could suffer significant losses if they end up paying more than they bargained. Many hedge their exposure by buying and selling shares of the underlying stock.

When the share price edged closer to the high strike prices of bullish investors, hordes of people bought call options. Also, it is leaving market makers with massive short gamma positions.

The stock price has skyrocketed.

A group of retailer traders (mainly from Reddit's stock and options trading subreddit r/wallstreetbets) coordinated a bid to raise the stock price. There was also a motive for 'getting back' or trolling Wall Street traders making money by betting on struggling companies' shares falling in value.

To mitigate the risks, market makers were forced to take out prominent short positions. The price rose significantly due to the gamma squeeze by market makers as the price rose unexpectedly. Since its release, AMC's gamma squeeze has become a popular benchmark.

How did the price of AMC stock change?

Reddit's stock and options trading subreddit r/wallstreetbets (mostly a group of retail traders) coordinated a bid to drive up the stock price. In part, the objective was to 'troll' sophisticated Wall Street traders who were betting on the decline in value of struggling companies' stocks.

Due to this, market makers were forced to take huge short positions in order to mitigate the risks. As a result, the market makers were gamma squeezed when the price rose unexpectedly, causing it to surge significantly. After its release, AMC's gamma squeeze became a popular benchmark in the markets.

What is the difference between Gamma Squeeze and Short Squeeze?

Gamma squeezes are similar to short squeezes; however, unlike short squeezes, a gamma squeeze is caused by the market maker, not by a trader.

Gamma squeezes occur when price movements and trading volumes are erratic, causing market makers to exit their positions. Gamma squeezes can cause a spike in price as a result of the large volume of transactions.

In contrast to gamma squeezes, short squeezes are experienced by traders, not by market makers. Similarly, traders may have to exit their positions when the market rushes due to extensive trade volumes in a specific direction.

This will either happen by choice (due to their losses) or by margin call, which is when your account runs out of money to cover your trades. In this situation, the trader is forced to sell or add more funds to their trading account.

Many stocks have skyrocketed as a result of these short squeezes.

As shown below, the Volkswagen (VOWG) share price quadrupled in two days from €210 to over €1000 in October 2008. As a result, Volkswagen became the most valuable company in the world for a brief period.

Mostly these two factors combine to increase the value of a stock over a short period, and they almost always work in tandem to cause an explosive move.

Short Squeeze

The shares that you purchase at your brokerage firm are known as "street names". By doing so, the brokerage is holding your shares but not registering them in your name. These shares will be available for short-sellers to borrow to profit from the drop in value of the shares.

Your shares are immediately sold after I borrow them. I am required to return them. Borrow fees can range from practically nothing (say, 0.3% of the price of the shares) to over 1,000% in some cases. You will be charged interest (usually split between the broker and the client) to borrow these shares.

Consider a stock that seems to be on the verge of failure. Millions and millions of shares are "shorted" as short sellers continue to bet that the price will drop.

We'll assume that this stock is $10, and we'll also suppose that the company makes a positive announcement. The stock increases to $15. As a result, short-sellers must "cover" their shares if they want to exit their short positions. They must buy them back to return the borrowed shares to you (remember, your shares were sold).

If I were to borrow your collector Corvette worth $75,000, how would you feel? Since I guessed that there would be a greater supply of these cars than previously thought, I predicted a drop in the price of the Corvette. In exchange for borrowing the vehicle, I will be charged $2,500 a month.

I take the car to a local dealer and sell it for $75,000.

The price of car drops to $50,000 six months later. You can have the keys returned to you when I buy back the car for $50,000. My profit is $10,000 after I pay your $15,000 fee for borrowing the car ($2,500 x 6). The Corvette's price could rise if it starts to rise in price. As I must return the car to you, I might panic and try to buy it back at a loss.

As a result, the dealership quotes me $95,000. However, I do not purchase the vehicle. It turns out that many other people sold their borrowed cars, hoping to make a profit as their value declined. These car short-sellers are all now interested in buying the car back, in addition to the legitimate increased demand. As a result, the car's value increases.

The stock market works like this - when the price goes up, short-sellers capitulate and repurchase their shares to get out of their positions. This creates a genuine demand for the stock from longs as well as short-sellers covering their positions. The higher the stock rises, the more pressure short-sellers feel.This is called a "short squeeze".

Gamma Squeeze

There are a lot of options involved in the gamma squeeze.

Take Gamestop as an example. You buy $50 calls that expire in a month when the stock is trading at $30.

You are buying options that are being sold to you. It is common for the person on the other side of the trade to be a "market maker".

A "market maker" essentially buys from people who want to sell and sells to people who want to buy. It is the spread between the best selling and best buying price that makes the market make money.

It's not very popular for market makers to sell many options, as they are taking on unlimited risk. Instead, they will buy shares of common stock to hedge their positions.

Delta refers to the amount by which an option moves up or down compared to the underlying stock's movement.

So, if the Delta call option is 0.30, the option will switch upto 30 cents for a dollar.

Market makers hedge their call sales using the "Delta" of the option. The higher the Delta, the more shares the market maker will need to buy if they have sold options.

Gamma, on the other hand, is the change in a Delta's value. The call option will become more "in the money," and the Gamma will increase with the stock rising. I don't think you need to understand this.

Nevertheless, market makers must be aware that if they sell an out-of-the-money call and the stock rises, they will have to buy more shares to protect their position continually. Gamma will increase as the market maker buys more shares.

Thus, if you purchase a $1,000 call option in Tesla at $500, then the maker will need to buy maimum shares as the stock increases to $600, $700, $800, 900, and ultimately $1,000. Gamma increases due to this. "Gamma Squeeze" is what it is called.

What Gamma Squeezes mean for stock traders?

When a company's stock price moves fast, there is a squeeze. A stock price rises when investors buy instead of sell. Gamma squeezes force investors to purchase more stock because open options on the underlying stock are involved.

Spikes or dips in the stock price indicate that a squeeze is occurring. Traders may experience short-term turbulence due to this squeeze because it usually corrects itself over time.

Gamma squeezes happen when a company gets big news that the market reacts erratically too. Because of this behavior, short-term volatility is extremely high, resulting in the squeeze.

Conclusion 

Gamma squeeze meaning can be an excellent opportunity for investors, but it can also pose a risk. If you're considering using this type of trading strategy, timing is crucial because share prices can rise unexpectedly, and reversals can also happen quickly.

Options trading is generally a risky business, especially for new investors. You may want to consider talking to a financial advisor who can explain how to spot gamma squeezes in options trading.

• Gamma squeezes result from a spike in trading volumes in one direction over a short period of time. In response to these volumes, the market maker closes out their positions, causing a spike in the share price known as a gamma squeeze.

• The market maker causes a gamma squeeze, while a trader causes a short squeeze.

• Gamma squeezes can be traded by identifying the events leading up to them and reacting quickly when the opportunity arises.

• GameStop and AMC are both excellent examples of gamma squeezes.