February 1, 2023

What is a gamma squeeze? : options

It has been a fine day in the stock market, and I’ve noticed across reddit, stocktwits, and twitter, that there seems to be a bit of confusion surrounding what a gamma squeeze is.

Let’s clear that up right now.

To understand a gamma squeeze, a bit of options trading knowledge is required. A call option is the right to buy 100 shares of stock at a given price, called the strike price, within a given amount of time.

When an options trader or investor buys a call option, someone needs to be on the other side of the transaction and be willing to sell them the 100 shares. This other party is usually a market maker – traders who work for an exchange, bank or company and are mainly looking for small steady profits rather than accumulating a massive speculative bet (although they may do this as well).

When many people buy call options from a market maker, the market maker is effectively taking on a large short position in the stock. If the price of the stock rises, they face large losses. To mitigate this, they start buying the stock to hedge their short options position. This ironically has the effect of pushing the stock price up – the very thing they don’t want.

This is where gamma comes in, and to understand gamma, we need to understand delta. These terms are both known as ‘Greeks’, and they tell options traders how the option acts relative to the underlying stock.

Delta is how much the option price will move relative to a move in the underlying stock. For example, a delta of 0.3 means for each US dollar the stock price moves, the option premium will change by 0.3. Delta fluctuates from 0 to 1.

When a stock is trading well below a call option’s strike price, then the delta is near 0. The option premium doesn’t move much. When a stock is trading well above a call option’s strike price then the delta is near 1. For each US dollar the price moves, so will the option.

Gamma is the change in delta for each dollar the stock price moves.

Delta tells the market maker how much they need to hedge. Assume a market maker is short by issuing and selling 1,000 call contracts (100,000 shares) at a strike price of $10 and the stock is currently trading at $8. There is no danger to the market maker because the stock is below the strike price, and not even near it.

The delta may be 0 or 0.1 on a position like this, meaning the market doesn’t need to hedge at all, or they buy 10,000 shares as a partial hedge (delta of 0.1 x 100,000 shares). But if the stock price rises, delta approaches 0.5 at the strike price. Gamma measures this change.

The chart below shows a sample graph of what an options delta chart would look like for a long call option on a stock. A long call option gives its holder the right to buy 100 shares of stock at a given price, while the seller of the option will hold the reciprocal obligation to sell those shares at the exercise price. Looking to the chart, option delta is a nearly flat line around zero when a stock’s price is well below the option’s exercise price. It is also a nearly flat line around 1 when that stock’s price is well above the option’s exercise price.

As the stock price rises the market maker must keep buying more stock, further fueling the rally, to adequately hedge. Delta can also be seen as the probability of an option expiring in the money, so for example, an option with a delta of 0.7 will have a 70% chance of expiring in the money. When the stock is at the strike price the market maker will usually have at least 0.5 of the position hedged, or 50,000 shares in order to cover off the 50% probability that the call will expire above the strike price and their exposure to potentially needing to deliver the shares to the call buyer. As the price keeps rising, so does delta, eventually reaching 1, which means the whole options position must be hedged. That means buying 100,000 shares.AMC Entertainment and GameStop are two examples of US stocks that experienced significant gamma squeezes.

In the case of AMC Entertainment and GameStop, both stocks were already being accumulated and hyped by WallStreetBets, a large group of retail traders in the popular discussion forum Reddit. Along with stock buying, hundreds of thousands of call options were purchased by retail investors, with the market makers on the other side of the trade.

As the prices of each stock rose, it created a gamma squeeze where the market makers were forced to buy the stocks and push both stocks prices up even more. It formed a vicious feedback loop, which resulted in GameStop jumping more than 2,000% in a couple weeks, and AMC Entertainment rallying close to 800%. The rally was also fuelled by hype, and not the gamma squeeze alone. The gamma squeeze helped to push the price up.

These examples can also be classified as a short squeeze​​ because there were large short positions in the stocks themselves.

Robinhood’s stock also experienced a gamma squeeze. Like the run-up in AMC Entertainment and GameStop, Robinhood became a ‘meme stock​’ with a lot of retail interest around it. Once again, this buying interest in the stock, coupled with large call option purchases, meant market makers were also forced to buy into an already escalating rally.

At the time in early August 2021, Robinhood had recently completed its IPO. Options on Robinhood commenced trading the day before a 50% stock price jump and gamma squeeze, resulting from the mass number of options that were purchased in the first two days of options trading.

One of the biggest examples of a gamma squeeze was when SoftBank, a Japanese technology investment company, earned the moniker “Nasdaq whale” after it bought billions of dollars’ worth of US equity derivatives in the technology sector in 2020. It had been buying massive amounts of call options on indices and ETFs as well as individual stocks like Tesla, Amazon, Alphabet and Microsoft, which stoked a feverish rally in tech stocks.

Are gamma squeezes a double-edged sword?

Gamma squeezes are sometimes referred to as a “double-edged sword” as they can propel prices in either direction. If the market maker has a short options position, then the price of the stock is pushed higher.

If the market maker has a net long options position, then they sell the stock to hedge, and the stock price is pushed lower. Trying to capitalise on this scenario is far less popular than where the stock price is squeezed higher.

Whether the gamma squeeze pushes a stock price up or down, the hedge does not need to last forever. As the options expire, or the hedge is no longer needed (or reduced) because delta changes, the stock price typically has a hard move back in the other direction. What goes up, comes back down.

How can I take advantage of gamma squeezes?

As the stock price rises, the gamma squeeze could help exacerbate the rally, which could lead to bigger profits on a long position.

A swift exit is a vital component to successfully capitalising on a gamma squeeze as the rally may not last long. Consider using a trailing stop loss or some other exit method that protects you from downside volatility and locks in some profit, so the profits are not all given back when the reversal move occurs. Managing your risk and guarding against downside volatility can also be a vital component to successfully trading a gamma squeeze.

Stocks are affected by multiple factors, not just gamma squeezes. That means a gamma squeeze won’t always result in a big move higher in stock prices, and big moves higher can occur without a gamma squeeze.

How this ties in with ESSC:

Today, ESSC experienced a runup that put a significant number of call options in the money, which in turn places pressure on market makers to hedge their positions by accumulating shares. This feedback loop will in turn raise the stock to even higher prices, with pressure increasing as more and more of the chain comes ITM.

r/options - ESSC: What is a gamma squeeze?

Currently, 214% of the float is accounted for by ITM options. Market makers will have to hedge for these calls, so long as they are held to expiration. Through hedging, buying pressure will increase, putting more strikes in the money, until every available strike is ITM.

When this happens, the market makers will open up new strikes on the options chain. We saw this happen in December, though the run was killed prematurely due to certain “influencers” dumping their positions and tweeting about it. This time, however, there is more powder. This setup is much more bullish than the previous runup in December, with most of the options being taken prior to the stock breaking $11.

After opening up new strikes, you can expect to see a lot of hedging during After hours and premarket, to get retail frothing at the mouth to enter new strikes. This is the day that ESSC will likely hit it’s peak. However, if this were to occur significantly before options expiration, there is a chance depending on how retail responds to the chain extension, that the run can continue. That’s really going to depend on how many options holders choose to take profit and/or roll up to higher strikes.

For this gamma squeeze to play out, market makers must be enticed to hedge. The entire chain should go ITM. There should be a significant options chain extension, and a huge rally in after hours the day before/of.

To get an idea of what price action would look like in the event of a gamma squeeze on a low float stock, take a look at IRNT’s chart from September.

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