What is a Gamma Squeeze & How can it Affect Your Trading?

Investing’s “squeeze” occurs when the stock price of a company moves rapidly. Whenever this happens, investors may exhibit “squeezed” and seem to change their stock positions in ways they hadn’t intended. These changes usually cause stock prices to rise.

Gamma squeezes usually occur when introduced options in the current stock force investors to buy more stock. As shares of entertainment holdings increased suddenly in early January 2021, a gamma squeeze was at play.

What is the Meaning of a Gamma Squeeze?

In the derivatives market, gamma squeezes are part of options trading. Gamma is used to determine the price of these derivatives through a series of mathematical calculations. When the derivative is very close to the actual price of the share, Gamma is at its highest level.

For a trader to buy or sell options, a market creator must be able to provide the asset at the specified price upon redemption. Large positions in the market are often taken by market inventors to counteract these large risks.

The market maker can be forced to buy out or sell their positions when traders overwhelm the market by buying or selling a specific asset in a large volume.

A surge in the price of the underlying shares occurs when market makers buy or sell their positions. It is called a gamma squeeze.

How does Gamma Squeeze Work?

It can only occur if certain conditions are met. It begins when investors make assumptions about the stock’s price. More specifically, they believe the stock will appreciate.

A large number of call options that have a short date in the stock are bought in this way. When the underlying stock it’s associated with value increases, the call option’s value increases. The result is a short position for the institutional investors who are selling the options.

If investors continue to sink more money into call potions, that can force institutional investors to purchase more shares. The hedge is necessary to protect themselves from the short position they now find themselves in.

Gamma squeeze occurs when the price of an underlying stock rises quickly within a short period. As investors pour money into call options, that forces more buying activity, which can lead to a rise in stock prices.

If investors buy call options and sell them during times of high stock prices, they can make significant profits, but institutional investors who cover short positions may see significant losses.

What causes a Gamma Squeeze?

Gamma squeezes occur when large volumes of trades are executed in one direction quickly. As a result, the market makers are forced to close out their positions, resulting in a spike in the share price.

The market is heavily influenced by news from around the world and trader sentiment. It is not uncommon for trade volumes in a specific direction to be larger than usual when big news breaks.

High market volumes can be beneficial for traders, but they cause difficulty for market makers and frequently force them out of positions.

A large volume of transactions puts further pressure on the share price when they buy or sell out of their positions in the underlying asset. Market makers strive to hold on and mitigate risk where they can, but it is not always possible in a fast-paced, volatile market.

Is it Possible for Gamma Squeeze to Work Both Ways?

Certainly. Market makers can be short gamma by either selling calls or puts. To hedge their exposure, market makers sell a falling stock if it is falling.

Analysts said, however, that downward pressure on shares from gamma-induced selling is generally less extreme than upward pressure on shares.

What happened to the AMC stock price?

The stock price of the company was pumped up by retailers (mostly members of Reddit’s stock and options trading subreddit r/wallstreetbets). Among the motivations was to ‘get back’ or ‘troll’ sophisticated Wall Street traders who made money by betting on the decline in stock value of struggling companies.

Thus, market makers were forced to take out large short positions to hedge against the risks. The market makers, however, were gamma squeezed when the price rose unexpectedly, leading to a significant increase in price. As a result, AMC’s gamma squeeze is a popular reference point in the market.

Market makers who were gamma-squeezed repurchased their short positions, and shares surged in price. After the price dropped sharply, it corrected back to normal levels shortly thereafter. It may have corrected, but many traders were able to profit.

What Gamma Squeezes Mean for Investors

Gamma squeezes can present opportunities for investors, but they can also be risky. These short squeezes and their gamma squeezes can last for days or weeks or peter out very quickly, depending on what drives them.

As a result, timing plays an important role in determining whether or not your portfolio experiences a profit or loss from gamma squeeze.

Whenever gamma squeeze reaches its peak, price reversals can occur very rapidly, resulting in a steep decline in stock prices. 

Because of this, trading options may not be suitable for every investor unless you have a high tolerance for risk.

Trading options are generally riskier than trading stocks, mutual funds, or ETFs because there is a certain amount of guesswork involved with what a stock’s price will do. Make a good guess and you could earn a handsome return. Make a mistake, however, and you might suffer severe losses.

How to Trade Gamma Squeeze

In order to trade gamma squeezes, you must be comfortable with risk. There is no such thing as a typical gamma squeeze because each situation is different. Others will take place over weeks or months with very sharp peaks and price changes.

Timing is key to trading gamma squeezes. The speed at which gamma squeeze unfolds means a trader who cannot identify and trade the situation quickly will lose out. Quick and responsive trading platforms are also essential.

You should look out for two factors of gamma squeeze:

• Interest in shorting stocks is high: 

For a squeeze to occur, there must be traders who become stuck. Short traders are the most common type of traders who become stuck

• Choosing an option: 

Gamma squeeze is not complete without options. There is less market maker movement when traders play options. Because of this, fewer positions are squeezed

Gamma squeeze trading steps

• Register or log into your account
• Research the market you wish to trade
• Analyze the situation
• Managing your risk is important
• Your position should be opened, monitored, and closed

What is the Duration of Gamma Squeeze?

Gamma squeezes can persist for hours, days, or weeks. It depends on what is causing them. It is impossible to sustain gamma squeezes over a long time, so timing is key, as costs can escalate quickly within a little time, and reversals could also take place quickly. The reversal of stock prices can lead to massive losses if the movement in the reverse direction occurs.

Bottom Line

Gamma squeezes can cause significant volatility and instability, so they should be investigated.

For gamma squeeze, stocks such as GameStop, which are heavily shorted by institutional investors and hedge funds, are ideal. Short-sellers are relied upon to execute hedging actions during a squeeze.

The largest sellers of options are investment banks and brokerage firms that hedge their positions. These firms frequently adjust the amount of the hedge based on the delta of the option.