What Is a Gamma Squeeze and How Does It Work?
Uncover the mechanics of a gamma squeeze, a distinct market event driven by options trading and market maker hedging that impacts stock prices.
Uncover the mechanics of a gamma squeeze, a distinct market event driven by options trading and market maker hedging that impacts stock prices.
A gamma squeeze is a financial market phenomenon that can lead to rapid and significant price movements in an underlying stock. This event occurs through an interaction between options trading activity, the underlying stock’s price, and market maker hedging strategies. It represents a scenario where increased buying of specific options contracts creates a self-reinforcing upward pressure on a stock’s price. Understanding this dynamic requires examining options and the role of market participants.
Stock options are financial contracts that grant the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price by a specific date. A call option provides the right to buy the underlying stock, while a put option provides the right to sell it. Key terms include the strike price (the price at which the option can be exercised) and the expiration date (when the contract ceases to exist). Each standard option contract represents 100 shares of the underlying stock.
Market makers play a role in the options market by providing liquidity. They facilitate trading by simultaneously offering to buy (bid) and sell (ask) options, profiting from the small difference between these prices, known as the bid-ask spread. Market makers aim to maintain a “delta neutral” position to mitigate the price risk associated with the options they trade. This means they balance their exposure so their portfolio’s value does not change significantly with small movements in the underlying asset’s price.
To achieve delta neutrality, market makers engage in hedging activities. When a market maker sells call options, they are obligated to deliver shares if the option is exercised. To offset this risk, they buy shares of the underlying stock. Conversely, if they buy call options, they might sell shares to hedge. This continuous adjustment of their stock positions based on options exposure impacts the underlying stock’s price.
The mechanics of a gamma squeeze are rooted in how options’ sensitivities to price changes, known as “Greeks,” influence market maker hedging. Delta measures how much an option’s price is expected to move for every $1 change in the underlying stock’s price. Gamma measures the rate at which an option’s delta changes for every $1 change in the underlying stock’s price. Gamma is highest for options that are “at-the-money” (strike price close to current stock price), and it increases as options move “in-the-money” (stock price rises above call strike).
As the underlying stock price rises, the delta of call options sold by market makers also increases. To maintain their delta-neutral hedge, market makers must buy more shares of the underlying stock. This is because their exposure to the stock’s price movement becomes greater as the options they sold become more likely to be exercised. This increased buying by market makers pushes the stock price higher.
This creates a positive feedback loop characteristic of a gamma squeeze. A sudden surge in call option buying drives up the stock price. As the stock price rises, more call options move into or closer to being in-the-money, causing their gamma, and consequently their delta, to increase. This requires market makers to buy even more shares of the underlying stock to re-hedge their positions, which further pushes up the stock price.
A gamma squeeze begins with a significant increase in call option volume. This heightened activity signals strong speculative interest in the underlying stock. It indicates many market participants are anticipating a rapid upward movement in the stock’s price, prompting market makers to adjust their positions.
A gamma squeeze is distinct from a short squeeze, though they can sometimes occur simultaneously. A short squeeze is driven by short sellers covering their positions, which involves buying back shares to close out bets that a stock’s price will fall. In contrast, a gamma squeeze is driven by market makers hedging their options positions by buying the underlying stock. While both phenomena can lead to rapid price appreciation, their underlying mechanisms involve different market participants and motivations.
The market impact during a gamma squeeze includes rapid and volatile price appreciation in the underlying stock. There is also an increase in trading volume as both options and stock activity intensify. This heightened volatility can lead to significant price swings, presenting both opportunities and risks for market participants.