What Is a Gamma Squeeze and How Does It Work?

A gamma squeeze is a rapid and significant increase in a stock’s price, originating from options trading dynamics. This phenomenon leads to substantial volatility for the underlying shares, creating a reinforcing cycle that drives prices upward.

Core Components of Options Trading

A stock option is a financial contract granting the buyer the right, but not the obligation, to buy or sell a specific number of shares of a company’s stock. This right is exercisable at a predetermined price, known as the “strike price,” and within a specified timeframe, called the “expiration date.” Options are derivatives, meaning their value is derived from an underlying asset, typically a stock.

There are two primary types of options: call options and put options. A call option gives the holder the right to purchase the underlying asset at the strike price, and buyers use them when they anticipate an increase in the stock’s price. Conversely, a put option grants the holder the right to sell the underlying asset at the strike price, and these are bought when a decline in the stock’s price is expected.

The price paid by the option buyer to the seller for this contract is called the “premium.” This premium is influenced by various factors, including the underlying asset’s current price, the strike price, the time remaining until expiration, and the implied volatility of the asset. Option buyers risk only the premium paid if the option expires worthless, while option sellers (also known as writers) receive the premium but assume the obligation to fulfill the contract if exercised.

The Mechanics of Delta and Gamma

Delta is a measure used in options trading to quantify an option’s sensitivity to price changes in its underlying asset. It estimates how much an option’s price will change for every one-dollar movement in the underlying stock’s price. For call options, Delta values range from 0 to 1, indicating that the option’s price will move in the same direction as the stock but by a smaller amount. Put options have a Delta range from -1 to 0, signifying that their price moves inversely to the stock.

Market makers, who facilitate options trading by quoting both buy and sell prices, manage their risk exposure through a practice known as delta hedging. When market makers sell options, they incur a directional risk because they are obligated to fulfill the contract if the option is exercised. To mitigate this risk, they buy or sell shares of the underlying stock to maintain a “delta-neutral” position, aiming to offset potential losses from their options positions with gains or losses from the stock. This dynamic adjustment ensures that their overall portfolio value remains relatively unaffected by small price changes in the underlying asset.

Gamma indicates the rate of change of an option’s Delta. It measures how much Delta will increase or decrease for every one-dollar move in the underlying asset’s price. Gamma is highest when an option’s strike price is near the current stock price, a condition known as “at-the-money.” As the stock price moves further from the strike price, Gamma decreases. A high Gamma means market makers’ Delta changes rapidly, forcing them to frequently adjust stock holdings to maintain hedged positions.

The Gamma Squeeze Phenomenon

A gamma squeeze materializes when specific market conditions trigger a self-reinforcing cycle of buying pressure on a stock, driven by options trading dynamics. This begins with a surge in demand for call options, particularly those that are out-of-the-money, meaning their strike price is above the current stock price. This increased buying activity can be fueled by speculative interest or a collective belief that the stock’s price will rise significantly.

As the underlying stock price starts to climb, the out-of-the-money call options sold by market makers begin moving closer to their strike prices. This movement causes the Gamma of these options to increase substantially. With higher Gamma, the Delta of these options changes more dramatically with each subsequent price movement in the stock.

To maintain their delta-neutral positions and manage their risk, market makers are compelled to purchase more shares of the underlying stock as its price rises and the Delta of their sold call options increases. This forced buying by market makers creates additional demand for the stock, further pushing its price upward. The rising stock price, in turn, causes the Gamma of the options to increase even more, requiring market makers to buy even larger quantities of shares to re-hedge.

This creates a positive feedback loop: rising stock prices force market makers to buy more stock, which further accelerates the price increase, leading to even higher Gamma and more forced buying. The characteristics of a gamma squeeze include rapid, parabolic price movements in the stock, accompanied by high trading volume and increased market volatility. These events can be short-lived but impactful, demonstrating the interconnectedness of the options and equity markets.