Gamma Squeeze Explained: What It Is and How It Works

Gamma squeezes are one of the most exciting and volatile phenomena in the stock market. When triggered, they can lead to dramatic price movements, creating significant opportunities for traders to capitalize on. But what exactly is a gamma squeeze? How does it happen, and what can traders do to navigate these intense market conditions? In this article, we’ll break down the concept of a gamma squeeze, how it works, notable examples, and key strategies to trade effectively during these explosive price surges.

What is a Gamma Squeeze?

A gamma squeeze is a market phenomenon that occurs when the price of a stock increases rapidly due to the actions of market makers involved in options trading. This happens when there is a large influx of call options being purchased on a particular stock, which leads to an increase in the stock’s price. A call option gives the buyer the right, but not the obligation, to purchase a stock at a specific price (the strike price) within a set period. When many traders buy call options, it creates a demand for the underlying stock, causing its price to rise.

Market makers—financial entities that provide liquidity by buying and selling options—are obligated to sell these call options to traders. However, because they are exposed to the risk of the stock’s price rising (since the options give the buyer the right to purchase the stock at the strike price), they need to hedge their positions. To do this, market makers buy the underlying stock, which helps to neutralize their risk. This process of buying shares to hedge against the increasing likelihood that the options will be exercised leads to a further increase in the stock’s price.

As the stock price continues to rise, the delta of the call options increases. Delta refers to the rate at which an option’s price changes relative to changes in the price of the underlying stock. For example, if the stock price rises, the delta increases, meaning that for every unit of stock price movement, the market maker must buy even more shares to maintain their neutral position. This creates a feedback loop, where the increasing price forces the market makers to buy more, which drives the price even higher, causing more options to be exercised, and so on.

This loop of rising prices continues until the gamma squeeze runs its course. The resulting price movement can be dramatic and volatile, often leading to significant swings in the stock price within a short period. The squeeze typically subsides once the options expiration date arrives, or once the demand for call options decreases. While gamma squeezes can result in massive short-term profits for those who capitalize on the price movement, they also carry high risk due to the volatility involved.

What Causes a Gamma Squeeze?

A gamma squeeze is typically caused by a combination of three factors: high options volume, rising open interest in call options, and the need for market makers to hedge their positions. Here’s a breakdown of the primary factors that contribute to this phenomenon:

1. Options Volume and Open Interest

When a large number of call options are bought at a particular strike price, the increased trading volume can influence the option price and attract more traders’ attention. Market makers (who often sell these options) must hedge their positions by purchasing the underlying asset. The more call options traded, especially at key strike prices, the greater the buying pressure on the underlying stock.

2. Delta and Gamma

The key options “Greeks” involved are delta (the rate of change in an option’s price relative to the underlying asset) and gamma, which measures the rate of change of delta as the underlying stock price moves. The relationship between the stock price and the option’s strike price, especially the call option’s strike price, is crucial in determining how much hedging is required. As the stock price rises and approaches or surpasses the option’s strike price, delta increases, forcing market makers to buy even more stock to maintain their hedges. This gamma effect, as gamma measures the sensitivity of delta to price changes, can drive the stock price further up.

3. Market Sentiment

Often, a gamma squeeze is driven by speculative buying, especially in volatile markets, as traders act on expectations of future price movements in the underlying stock. Retail traders or large institutional players may push the stock price higher, contributing to a self-perpetuating cycle of buying.

The Key Players Involved in a Gamma Squeeze

Understanding the key participants in a gamma squeeze is crucial to identifying the forces driving the market:

• Market Makers: These are the financial entities responsible for providing liquidity in the options market. They sell options contracts to traders and hedge their risk by buying or selling the underlying stock. When a gamma squeeze occurs, market makers are forced to buy more shares of the underlying stock to balance their positions, which drives the stock price higher.
• Retail Traders: Retail traders often contribute to a gamma squeeze by buying call options in large quantities. As their activity increases, they create the buying pressure that leads to a significant rise in the stock price.
• Institutional Investors: While gamma squeezes are often triggered by retail traders, institutional investors can play a role in amplifying the event. Large institutional players may contribute to the rally by buying additional options or shares, further driving the squeeze.

Gamma Squeeze vs. Short Squeeze: What Are the Key Differences?

While both gamma squeezes and short squeezes can result in dramatic price movements, they occur through different mechanisms and involve different market dynamics. The table below shows the key differences between a gamma squeeze and a short squeeze, helping to clarify how each one operates and the forces behind them.

• Gamma Squeeze: A gamma squeeze is triggered when there is significant buying activity in call options. Market makers, who sell these options, are required to hedge their positions by purchasing the underlying stock. As the stock price rises, market makers need to buy even more shares to adjust their hedge, creating a feedback loop of increasing prices.
• Short Squeeze: A short squeeze, on the other hand, happens when short sellers—who have bet against a stock—are forced to buy back shares to cover their positions as the price unexpectedly rises. This buying pressure from short sellers further drives the price higher, triggering even more buying.

While both squeezes are driven by a surge in buying pressure, the key difference is in the cause: a gamma squeeze is driven by options traders and the need for market makers to hedge, while a short squeeze is caused by short sellers scrambling to cover their positions.

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Notable Example of Gamma Squeezes

A gamma squeeze can lead to dramatic price movements, as shown in these notable examples, where the buying of call options triggered significant surges in stock prices due to the hedging activities of market makers.

1. GameStop (GME) – January 2021

The GameStop gamma squeeze is perhaps the most famous example of a gamma squeeze that also triggered a short squeeze. Retail traders, primarily from the Reddit group WallStreetBets, began buying massive quantities of out-of-the-money GameStop call options, which led to a surge in options volume. Market makers, who sold these options, were forced to buy GameStop stock to hedge their positions. This created a feedback loop where the rising stock price forced market makers to buy even more shares, causing the price to skyrocket from under $20 to over $400 in a matter of days. The gamma squeeze was further intensified by high short interest in GameStop, leading to a combination of both a gamma squeeze and a short squeeze.

2. AMC Entertainment (AMC) – May 2021

Similar to GameStop, the AMC gamma squeeze occurred in May 2021. AMC gamma squeeze explained: This event was driven by retail traders, particularly from online communities like Wall Street Bets, who bought up a large number of call options for AMC stock. This activity played a crucial role in preventing AMC’s bankruptcy during the COVID-19 crisis. As the price rose, market makers had to buy more shares to hedge, fueling the price increase even further. AMC’s stock, which had been trading around $5 to $10, soared to over $60 within a matter of weeks. The high demand for call options and the associated buying pressure created a classic gamma squeeze scenario.

3. Volkswagen (VW) – October 2008

One of the most remarkable examples of a gamma squeeze took place with Volkswagen (VW) stock in October 2008. During this time, Porsche revealed that it had acquired a majority of the outstanding shares of Volkswagen, putting pressure on short sellers. In response, many traders bought call options to capitalize on the potential rise in Volkswagen’s stock price. Market makers, who sold the options, were forced to hedge by buying more shares, driving the price of Volkswagen stock up from around €200 to over €1,000 within just a few days. This squeeze became one of the most extreme price movements in stock market history.

4. SoftBank (SFTBY) – 2020

Another significant gamma squeeze occurred in 2020 when SoftBank, a Japanese conglomerate, became a large player in the options market. The company made massive purchases of call options on various tech stocks, which sparked a rise in their prices. As the prices of stocks like Amazon, Apple, and Tesla began to surge, market makers were forced to buy more shares to hedge their positions, further escalating the price increases. This created a gamma squeeze that affected several high-profile stocks in a short period of time, showcasing the power of options in driving stock prices.

How to Spot a Gamma Squeeze

A gamma squeeze can be tricky to identify, but there are several indicators that can signal its onset.

1. Unusual Options Volume

One of the first signs of a potential gamma squeeze is a surge in call options volume. If you notice a significant increase in the number of out-of-the-money (OTM) call options being traded, particularly at the same strike price, it’s likely that market makers will need to hedge their positions. This can lead to increased buying pressure on the underlying stock.

2. Rising Open Interest

Look for a rapid increase in open interest for call options. When traders buy calls, especially in large quantities, it forces market makers to purchase more stock to hedge against potential price moves. This can amplify the gamma squeeze effect.

3. Increase in Implied Volatility

A sharp rise in implied volatility (IV) can signal that the market expects significant price movement. As IV rises, market makers may buy more of the underlying stock to hedge their positions, adding to upward price pressure and potentially triggering a gamma squeeze.

4. Rapid Price Movements

Watch for fast price increases without corresponding news or earnings reports. If the price rises quickly alongside increased options activity, it’s a strong indication that a gamma squeeze might be at play, as market makers scramble to hedge their options exposure.

How to Trade During a Gamma Squeeze

Trading during a gamma squeeze can be profitable but requires understanding the market dynamics. Here are the key steps to trade effectively during a gamma squeeze:

Step 1: Monitor Options Activity

Watch for high call options volume and rising open interest, which signal a potential gamma squeeze.

Step 2: Buy Call Options

If a gamma squeeze is forming, buying call options can offer high returns as the stock price rises. Opt for at-the-money options and be mindful of expiration.

Step 3: Enter the Stock Market

If you prefer buying the stock, enter when the price begins rising sharply. Timing is crucial—avoid entering too early or too late.

Step 4: Use Stop-Loss Orders

Protect your position with a stop-loss or trailing stop as the price rises to lock in gains while allowing for further movement.

Step 5: Take Profits

Exit the position when the price hits resistance or volume drops. Gamma squeezes are short-lived, so capitalize on the surge before it fades.

Step 6: Stay Alert for Reversals

Watch for quick price reversals after the squeeze peaks. Exit or hedge if the price starts to fall rapidly to protect your gains.

Key Considerations When Trading a Gamma Squeeze

Trading a Gamma Squeeze can be profitable, but it requires careful strategy. Here are the key considerations for trading a gamma squeeze effectively:

• Volatility: Gamma squeezes are often short-lived, with prices potentially experiencing sharp reversals. Traders should be aware of the risks and ready to exit positions quickly.
• Emotions: FOMO (Fear of Missing Out) can drive irrational trading behavior during gamma squeezes. Traders should stick to their strategies and avoid chasing the rally.
• Liquidity: Ensure there is enough liquidity in the stock or options you’re trading to avoid large slippage when entering or exiting positions.
• Timing: Timing is crucial. Gamma squeezes often happen quickly, and traders must be able to enter and exit the market efficiently to lock in profits.

Discover the best time to buy and sell stocks.

In Summary

A gamma squeeze occurs when a surge in call options buying forces market makers to hedge by buying the underlying stock, creating a feedback loop that drives prices higher. While trading during a gamma squeeze can be profitable, it’s essential to carefully monitor options activity, open interest, and stock price movements to manage risk effectively. Understanding the dynamics of the squeeze and timing your entry and exit points is crucial for maximizing profits.

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Frequently Asked Questions (FAQs)

1. What is a gamma squeeze?

A gamma squeeze occurs when a surge in call options buying forces market makers to buy more of the underlying stock to hedge their positions, driving the price higher.

2. What causes a gamma squeeze?

A gamma squeeze is caused by the rapid buying of call options, which forces market makers to buy the underlying asset to hedge their positions, driving the price higher.

3. How is gamma squeeze different from a short squeeze?

A gamma squeeze is driven by options buying and hedging, while a short squeeze occurs when short sellers are forced to buy back stock to cover their positions.

4. Can a gamma squeeze happen in any market?

Yes, a gamma squeeze can occur in any market where options are traded, but it’s more common in stocks with high volatility or speculative interest.

5. How does a gamma squeeze affect stock prices?

As market makers buy more stock to hedge their options, the increasing demand causes the stock price to rise, creating a feedback loop that drives prices even higher.

6. How to spot a gamma squeeze?

To spot a gamma squeeze, traders should monitor the following indicators:

• Unusual options volume
• Rising open interest
• Increase in implied volatility
• Rapid price movements

7. How to trade during a gamma squeeze?

Here are the key steps to trade effectively during a gamma squeeze:

• Step 1: Monitor options activity
• Step 2: Buy call options
• Step 3: Enter the stock market
• Step 4: Use stop-loss orders
• Step 5: Take profits
• Step 6: Stay alert for reversals

8. How long does a gamma squeeze typically last?

A gamma squeeze can last anywhere from a few hours to several days, depending on the level of options activity and market dynamics. It often ends when the options expiration date arrives or when the buying pressure diminishes.

9. Can a gamma squeeze happen with any stock?

While it’s possible for a gamma squeeze to occur with any stock, it’s more common in stocks with high volatility and significant options trading activity.

10. Can retail traders cause a gamma squeeze?

Yes, retail traders can drive a gamma squeeze by buying large volumes of call options, which increases demand for the underlying stock and triggers the hedging actions of market makers.

11. What are the risks of trading during a gamma squeeze?

The main risk is that gamma squeezes are often short-lived, and prices can reverse quickly. If you’re caught in the wrong position, you could face significant losses.

12. How can I protect myself when trading a gamma squeeze?

To protect yourself, use stop-loss orders, stay alert to price movements, and consider using hedging strategies like buying puts or selling call options to manage risk.