The finance world is chock full of strange terminology. “Gamma squeeze” is a perfect example.
In general, when there’s a “squeeze” in the market, that usually describes an event when investors feel pressure to make a move that they otherwise would not have made. For instance, in “short squeezes,” investors who made bearish bets on a stock–known as short sellers–are forced to buy shares of the stock they’ve actually bet against.
This piece will dig into what a gamma squeeze is, what it has to do with options trading, and what it means for investors.
Overview of Options Trading
It’ll be helpful if we quickly recap how options trading works. Options can be bought and sold, just like stocks. In short, they’re contracts that give purchasers the right (but not the obligation) to buy or sell an asset—i.e., the option to transact.
Options can be used to speculate on price changes. For example, if an investor thinks the price of a stock is going to increase, they can purchase an options contract to put themselves in a position to profit if their prediction were to come true.
There are call and put options to take into account. A call gives purchasers the right to buy an asset at a certain time or price, whereas a put gives them the right to sell it. Buying these types of options allows them to effectively bet on a stock, without outright owning it. Purchasers typically pay a small “premium,” or the price of the contract.
Generally, if an investor thinks a stock’s price will increase, they buy calls. If they think it will decrease, they buy puts.
Recommended: Options Trading Terminology
Gamma Squeeze Definition
A gamma squeeze has to do with buying call options. Remember, purchasers buy calls when they think the price of a stock is going to increase. And as the price of that stock increases, so does the value of the call option. Now, when a stock’s price starts to increase, that can lead to more investors buying calls contracts. There’s a whole lot of call-buying going on.
But on the other side of those calls are the traders or institutions that sold them—remember that options are a contract between two parties, so for an investor betting on a stock price’s increase, there’s another that’s betting that it’ll fall. They’re taking a “short” position, in other words.
“Market makers”–the trading firms that are selling the call options–are typically the party on the other side of the trade. They’re essentially “short” those call options that investors in the market are buying. These market makers face a good amount of risk if the price of the underlying stock rises, so they will buy some shares of the stock to hedge some of that risk.
Buying the shares also helps to ensure that they will be able to deliver the stock if they become “due,” or the investor exercises their call options.
However, if investors keep buying more and more calls, and the stock’s price increases, market makers need to buy more and more stock—increasing its price even further, and thus, creating a “squeeze.” The gains in share value cause the market makers to be more exposed, hence they need to hedge even more.
Part of this is also because the stock’s gains brings the options closer to the prices at which calls can be exercised.
Basically, the short positions held by some investors allows a gamma squeeze to happen. And if a stock’s price rises instead of falls, the shorters’ need to start buying the stock, further increasing its price, creating the feedback loop mentioned earlier.
Recommended: Shorting a Stock Explained
What’s Gamma in Options?
Okay, so you may have a grasp on how a gamma squeeze can occur. But we still need to talk about what gamma is, and how it fits into the picture.
Gamma is actually just one of a handful of Greek letters (gamma, delta, theta, and vega) that options traders use to refer to their positions. In a nutshell, “the Greeks” help traders determine if they’re in a good position or not.
For now, we’ll just focus on delta and gamma. Gamma is actually determined by delta. Delta measures the change of an option’s price relative to the change in the underlying stock’s price. For instance, a delta of 0.3 would mean that the option’s price would go up $0.30 for every $1 increase in the underlying stock’s price.
Gamma measures how delta changes based on a stock price’s change. It’s sort of a delta of deltas. In other words, gamma can tell you how much an option’s delta will change when the underlying stock’s price changes. Another way to think of it: If an option is a car, its delta is its speed. Its gamma, then, is its rate of acceleration.
When a gamma squeeze occurs, delta and gamma on options are in a state of flux, creating stock volatility and ultimately, squeezing some market players.
The Takeaway
When investors are making bullish bets on a stock, sometimes they use call options–contracts that allow them to buy a stock at a certain date in the future.
When brokers or market makers sell those call options to the investors, they buy shares of the underlying stock itself in order to try to offset the risk they’re exposing themselves to. This also helps them ensure they can deliver the shares if the options get exercised by the investor holding the call options.
Gamma squeezes occur when there’s rapid buying by the market makers of the stock, causing a dramatic surge in the share price. The sudden increase, in turn, causes greater exposure for the market makers, causing them to hedge themselves more by purchasing additional shares.
Options trading is complex and may not be for everyone. But if you want a simpler investing experience, then an online investing account with SoFi may be a good choice. SoFi Invest allows investors to buy and sell stocks, ETFs and fractional shares without commissions. Users can also start building a portfolio with as little as $5 on the Active Investing platform.
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