A gamma squeeze is an extreme situation where increased demand for call options drives a stock’s price upward. This is generally caused by broker/market makers who are forced to buy additional call options to hedge their existing positions. As the share price rises nearer the option’s strike price, so does gamma, which in turn drives the brokers to increase their hedge. It’s basically an infernal loop.
Let’s take a closer look at the nuts and bolts of what goes on in this type of situation. To understand a gamma squeeze it’s best to start by looking at the dynamics of a ‘basic’ short squeeze.
What’s a Short Squeeze?
Let’s first understand the basic ‘short squeeze’ scenario. This is when a trader finds himself with a short position on an underlying whose price suddenly moves up (against the trader) and where there is share scarcity.
If share price drops then trader profits …
Shorting a stock means that a trader sells shares with the aim of making a profit as the price of the stock declines. The trader has a bearish view on the stock. This means he hopes to make a profit as the value of the asset falls. Many times the trader won’t actually own the stock, preferring to borrow the underlying for a fee. When the trader is ready to close the trade, he’ll repurchase the shares in the market (he hopes at a lower price) and return them to the lender. If the share price has fallen during this period the investor will have made a profit. His net gain will be equal to the difference between his sale price and his purchase price (including his borrowing fee).
…but a share price rise can create a liquidity trap
BUT if the share price has risen during this time frame, then the investor faces a loss. This is because he must buy the stock at a price higher than at which he sold it initially. Also, to make matters worse, the trader may have to deal with share scarcity.
A rapid upward movement in the share price can attract new buyers. Unexpected positive news flow, such as a ground-breaking corporate merger announcement for example, could suddenly push the share price upward. Dramatically. New buyer interest in the stock could create scarcity in share availability, further driving up the price if there’s a small free float. If this happens it can compound the problem for the short seller. His losses would spiral upward while he was trying to locate shares to cover his short exposure. If a short seller finds himself trapped in his short position this is called a ‘short squeeze’. It’s a type of liquidity trap so to speak.
Let’s take a look at a diagram
Below is a diagram illustrating the sequence of events of a short squeeze.
When does a short squeeze happen?
Short squeezes tend to occur in stocks with a small quantity of traded shares. This can be the case of a small company with a small free float. Or a large cap whose investors don’t want to sell. And of course if a stock is already a popular target for ‘shorts’ then that will also reduce its free float. Companies suspected to be on the verge of filing for bankruptcy are often targets of short selling.
Also, stocks with high borrowing costs will make it more painful and urgent for short sellers to cover their short exposures if the share price moves against them. This can contribute to a panic frenzy among short sellers to run for their exit, further driving up the share price.
So what’s Gamma?
Gamma is one of the Greeks, a set of risk parameters used in options pricing. You can learn more about gamma on our Free education course where we delve into much more detail.
High Gamma vs. Low Gamma
But to summarize, gamma measures the rate of a change of another Greek: Delta. Delta measures the sensitivity of an option’s value to changes in the price of the underlying. Therefore gamma measures the rate of change in an option’s delta relative to changes in the price of its underlying asset. Options with a high gamma will be more responsive to changes in the price of the underlying when compared to options with a low gamma. Gamma is typically at its highest when the stock is trading at the option’s exercise price.
The relationship between an option’s value and the price of its underlying asset is constantly fluctuating. Because of this, traders need to continuously monitor their positions to make sure that they are properly hedged. Traders use gamma to reduce the risk to their position caused by potentially large swings in the underlying security. This is called ‘gamma hedging’. (Delta hedging1 alone is not sufficient when there are significant price moves).
Gamma Squeeze: “Short Squeeze on Speed“
A gamma squeeze is the equivalent of a short squeeze ‘on speed’. It takes things 1 notch higher in terms of impact. Ironically a gamma squeeze often occurs because market participants are trying to avoid a short squeeze.
Sometimes a short-seller will hedge himself to try to avoid a short squeeze trap. A common way to do this is by buying a call option. This partially protects the short-seller by creating a hedge in case the share price goes up. It also avoids him having to borrow the stock (see Short Squeeze section above). Buying a call option gives the short seller the possibility of buying the stock if it moves up; he won’t own the stock unless he exercises his option right. Buying a call option is like buying insurance ‘just in case something goes wrong’, and can be cheaper than borrowing the shares from a broker. If the short seller’s trade goes to plan (if the share price drops) then he won’t need to exercise his call option; it will simply expire.
So for example the short seller sells 10 shares at $50/share and also buys a $55 call ‘just in case’ the stock moves up. As a result, if the stock does rise, the option contract allows the short-seller to buy the stock if the share price trades at $55 or higher. The short-seller will be able to buy the stock at a discount thanks to the option. While the cost of the option is an extra expense for the trader, it can greatly reduce catastrophic losses if the market goes against his position. So if things go wrong, the option will definitely be worth it! Now let’s take a closer look at what else might be going on in the market and which could create a gamma squeeze.
…the broker needs to hedge
When the short seller buys a call option from a broker, that broker will typically want to hedge himself in case the short seller exercises his right to buy. If the share price rises to $60 and the short seller exercises his option right, the broker must sell him the shares at $55/share. But if the broker doesn’t actually own the shares, then he’ll be in a bind. This is why the broker will usually hedge himself when he sells a call in order to protect himself. He’ll usually do this by turning to another counterparty to buy a call option (or shares). This allows him to be ready to deliver if need be. And if he doesn’t need to exercise it then he won’t, no harm done. But at least he’ll have bought himself some insurance ‘just in case’.
…share price increase creates a gamma squeeze
If the share price increases from $50 to $60 this can attract 2 types of buyers which will add further pressure on demand:
– More short sellers
If the stock’s fundamentals are considered weak then short sellers will view the rise in the share price as a shorting opportunity. They will think that the increase in the share value is unjustified and that the share price is bound to fall. As more short sellers ‘short’ the stock they might buy call options to hedge themselves (as explained above for our initial short seller). This in turn will lead their brokers to buy more calls (or shares) so that they can hedge themselves.
– Long option buyers
Other investors may take a bullish view when they see the share price rise from $50 to $60. They might decide that there’s a quick profit to be made on the stock’s short-term momentum. This type of trader will buy a long call option from the broker who will, once again, hedge himself by buying a call option.
In both cases the increased demand by brokers for buying call options will put additional upward pressure on the stock price. This is because in all cases the broker is being forced to buy additional call options on the underlying to hedge his sales. And as the share price rises nearer to the option’s exercise price, so does gamma. Remember that 1) gamma is at its highest when the stock is trading at the option’s exercise price, and 2) gamma is used to reduce the risk in a position caused by potentially large swings in the underlying security (see section on Gamma above).
And this is how a dangerous loop is created.
1Delta hedging aims to reduce the directional risk associated with price movements in the underlying asset
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