In investing, a “squeeze” happens when there are swift movements of a company’s stock prices. When this occurs, investors often feel “squeezed” and tend to make changes in their stock positions that they hadn’t planned. The change in investors’ buying activity often drives stock prices up.
A gamma squeeze is usually extreme, forcing investors to buy more stock due to open options in the underlying stock. A gamma squeeze is behind what happened in early January 2021 as shares of GameStop and AMC Entertainment holdings rose suddenly.
What Is a Gamma Squeeze?
A gamma squeeze is often linked to options trading. Unlike stocks, options trading is somewhat different. When you open an options contract, you’re probably trading with a market maker and not an individual investor.
The primary goal of a market maker is to profit from the trade. They typically use a pricing model called the Black Scholes model to price options contracts. The price they’ll trade with you is actually based on the options pricing model. Furthermore, the market maker will likely hedge their positions by either buying or shorting the stock. It’s the hedging that can create conditions for a gamma squeeze to happen.
What Happens During a Gamma Squeeze?
As aforementioned, a gamma squeeze occurs when stock prices surge, forcing investors to change their stock positions. The squeeze can happen when there’s an extensive buying of short-dated call options of an individual stock, leading to a dramatic price surge. This can trigger investors to buy more calls, resulting in even higher stock prices.
One of the most popular squeezes is the short squeeze, which results when an increase in stock price forces investors who shorted the stock to buy back those shares, pushing stock prices higher. For a short squeeze to occur, short-sellers bet a decline in the price of a stock.
Gamma squeezes can offer a unique opportunity to investors and traders, but there’s a significant amount of risk involved. For this reason, timing is very important since the gamma squeeze can cause stock prices to drop sharply when they move in the opposite direction.
How a Gamma Squeeze Works
For a gamma squeeze to occur, several market conditions have to be met. It typically begins with investors betting that the price of an individual stock will rise. This brings about massive buying of short-dated call options.
When there’s large-scale buying of call options of the underlying stock, institutional investors will end up selling options in a short position. When the situation prolongs and investors continue to buy more call options, institutional investors might be forced to put more money into shares of the stock to ensure that they have very little or no net exposure.
As investors purchase call options of the underlying stock, it forces more buying activity, pushing up stock prices. And that’s how a gamma squeeze works.
A perfect example of a gamma squeeze is the GameStop stock saga that happened early this year. The stock price of the video game retailer rose by more than 400% at one point. As the attention for GME grew, the demand for GME call options also rose, forcing option sellers to hedge their risk by buying shares of the stock, driving prices higher.
While some investors reaped handsome profits during the GME squeeze, others faced steep losses.
How Long Does a Gamma Squeeze Last?
A gamma squeeze can last for days or even weeks, depending on what is driving the squeeze. Since gamma squeezes are not sustainable for the long term, timing is paramount as prices can rise sharply within a short period, and price reversals can also happen quickly. When stock prices reverse, the move in the opposite direction can lead to massive losses.
Good To Know
Volatility during and after a gamma squeeze is usually extreme. The best thing to do is wait until the squeeze ends so you can determine whether the stock offers you the investment opportunity you need.
A gamma squeeze can offer a significant opportunity to investors, but at the same time, it can also be risky. If you’re interested in taking advantage of this kind of trading strategy, timing is critical as share prices rise unexpectedly, and reversals can also happen quickly.
Generally speaking, options trading is a risky venture, especially if you’re new to investing. You may want to consider talking to a financial advisor who can walk you through how to spot a possibility of a gamma squeeze in options trading.