A gamma squeeze is a phenomenon in options trading that can result in rapid price increases for a particular stock or asset.

It occurs when market participants normally institutional investors or market makers are forced to buy shares of the underlying stock to hedge their positions as the price of the asset moves closer to certain major levels.

This chain reaction amplifies buying pressure, creating a feedback loop that drives prices even higher.

Gamma squeeze is needed by traders and investors, as it can create major short-term volatility and influence market sentiment.

Gamma in Options Trading?

To understand a gamma squeeze, you first need to grasp gamma in the context of options trading:

• Gamma measures the rate of change of an option’s delta.
• Delta is the sensitivity of an option’s price to changes in the price of the underlying asset.

Gamma is highest for options that are “at-the-money” (ATM), meaning the strike price of the option is near the current price of the underlying stock.

How a Gamma Squeeze Develops

1. Heavy Buying of Call Options

A gamma squeeze often begins when traders, particularly retail investors, buy large quantities of call options. Call options give the buyer the right to purchase the underlying asset at a specific price (strike price) before the expiration date.

2. Market Makers Hedging Their Positions

Market makers, who sell these call options, typically hedge their exposure by buying the underlying stock. This practice ensures that their risk remains neutral as the stock price moves.

3. Stock Price Increases

The increased buying of the stock pushes its price higher, especially if the options are heavily concentrated near certain strike prices.

4. Reinforcing Feedback Loop

As the stock price moves closer to or above these strike prices, the delta of the options increases. This forces market makers to buy even more of the stock to maintain their hedge, further inflating the price.

5. Rapid Price Surge

The feedback loop can lead to a dramatic spike in the stock price, which is the hallmark of a gamma squeeze.

Things that Drives Gamma Squeezes

1. High Open Interest in Call Options

A gamma squeeze is more likely when there is substantial open interest in call options at specific strike prices.

2. Low Liquidity

Stocks with lower trading volume are more susceptible to squeezes, as fewer shares are available to absorb the increased demand.

3. Short Interest

While not directly linked to gamma, high short interest can compound the effect. Short sellers may be forced to cover their positions as prices rise, adding another layer of buying pressure—a phenomenon known as a short squeeze.

4. Retail Investor Activity

Coordinated buying by retail investors and often seen on social media platforms or trading forums, can set the stage for a gamma squeeze.

Examples of Gamma Squeezes

1. GameStop (GME)

In early 2021, GameStop experienced a dramatic gamma squeeze fueled by retail investors purchasing out-of-the-money (OTM) call options. This led to a sharp rise in the stock price, exacerbated by a simultaneous short squeeze.

2. AMC Entertainment (AMC)

Similar to GameStop, AMC saw a gamma squeeze as retail investors flooded the options market, forcing market makers to buy shares and drive prices higher.

Risks and Rewards of Gamma Squeezes

For Traders

• Opportunities:
  Traders who anticipate a gamma squeeze can profit from rapid price increases by buying call options or the underlying stock early.
• Risks:
  The sharp rise in prices is often followed by equally steep declines, posing significant risks for latecomers.

For Market Makers

• Hedging Challenges:
  Market makers face the challenge of maintaining a neutral position in a rapidly changing market.
• Volatility Risk:
  Unexpected price surges can lead to increased volatility and greater exposure if not managed carefully.

How to Identify a Potential Gamma Squeeze

1. Unusual Options Activity

Monitor options chains for unusually high open interest or volume in call options, particularly at strike prices near the current stock price.

2. Price Movements

Look for stocks that are experiencing consistent upward price pressure, especially in low-float stocks.

3. Retail Investor Interest

Track mentions on social media platforms or forums where retail investors discuss potential plays.

Gamma Squeeze vs. Short Squeeze

While both gamma and short squeezes can drive rapid price increases, they differ in their mechanics:

• Gamma Squeeze: Triggered by market makers buying shares to hedge call options.
• Short Squeeze: Caused by short sellers buying shares to cover their positions as prices rise.

Conclusion

A gamma squeeze is a very interesting market event that show the relationship of some sort between options trading and stock price movements.

While it presents lucrative opportunities for savvy traders, it also carries substantial risks due to its unpredictable nature.