What is a gamma squeeze and how does it affect stock prices?

What is a gamma squeeze?

A gamma squeeze is a feature of the derivatives market as it forms part of options trading. The price of these derivatives are constantly determined through a series of mathematical calculations to display ‘gamma’. Gamma is at its highest level when the derivative is very close to the actual share price.

When a trader buys or sells options, the market maker needs to have the means to provide the asset at the required price when the option is redeemed. Market makers often take large positions in the market to counteract these large risks.

When the traders overwhelm the market by buying or selling a specific asset at a large volume, it can cause the market maker to buy out or sell their positions, leading to a large volume of trade in the market.

When the market makers buy or sell out of their positions, they cause a surge in the price of the underlying shares. This is known as a gamma squeeze.

What causes a gamma squeeze?

A gamma squeeze is caused by large trading volumes in one direction in a short space of time. This causes the market maker to have to close out their positions leading to a large spike in the share price.

Trade is heavily influenced by trader sentiments and world news. When big news breaks, it can lead to larger than usual trade volumes in a specific direction. While high market volumes can be good for traders, it makes it difficult for market makers and often leads to them being forced out of a position.

When they buy or sell out of their positions in the underlying asset, it puts further pressure on the share price due to the large volume. While market makers try to hold on and mitigate risk where possible, it’s not always doable in a fast paced, volatile market.

Gamma squeeze vs short squeeze: what are the differences?

A gamma squeeze is similar to a short squeeze; however, unlike a short squeeze a gamma squeeze is caused by the market maker and not by a trader.

A gamma squeeze is caused by erratic price movements and large trading volumes that cause the market makers to exit their trades. This can lead to a spike in the price due to the large volume traded by the gamma squeeze.

A short squeeze is a similar instance to a gamma squeeze but happens to a trader, not to a market maker. In similar cases where the market moves sharply due to large trade volumes in a specific direction, it can force traders out of their positions.

This’ll either be by choice (due to their losses) or even by margin call – an action when your account is running out of money to cover your trades. The trader is then forced to sell or add additional funds to their trading account.

These short squeezes have caused many stocks to skyrocket.

Below is a notable short squeeze that happened in October 2008, when the Volkswagen (VOWG) share price quintupled from €210 to over €1000 in two days. It caught the market completely by surprise and, for a brief period, Volkswagen was the most valuable company in the world.

How do gamma squeezes work in stock trading?

Gamma squeezes can cause spikes and dips in the stock price while the squeeze takes place. Often this squeeze corrects itself, but it can cause short-term turbulence for traders.

A gamma squeeze often follows some big news around a company that causes the markets to act erratically in either direction. This behaviour leads to extreme short-term volatility, which causes the squeeze to happen.

AMC gamma squeeze explained

AMC Entertainment is an American movie theatre group based in Leawood, Kansas. The company has become known globally after their short squeeze made markets go haywire in June 2021.

After the group posted a positive trajectory heading towards positive cash flows, no mean feat after the Covid-19 pandemic that halted and restricted their operations, many traders started speculating and buying call options at various prices.

What happened to the AMC stock price?

A loosely organised group of retailer traders (mostly from Reddit’s stock and option trading subreddit r/wallstreetbets) coordinated a bid to drive up the company's shares. Part of the motivation was to ‘get back’ or ‘troll’ sophisticated Wall Street traders making money by betting that struggling companies' stocks will decline in value.

Because of this, market makers were forced to take out huge short positions to offset the risks. However, when the price rose unexpectedly, the market makers were gamma squeezed, causing the price to rise significantly. AMC’s gamma squeeze has become a popular reference point in the markets since.

When the gamma-squeezed market makers bought back their short positions, the market saw a large surge in the share price. However, the price had a sharp decline shortly after where it corrected back to normal levels. While it may have corrected, many traders took advantage of the situation.

Other examples of gamma squeezes in history

Another popular example of a gamma squeeze was in early 2021, when GameStop was gamma squeezed by the r/wallstreetbets Reddit group. After rumours of bad results in late 2020, many traders were shorting the stock, including two big hedge funds.

In total, more than 100% of the company’s cash flow was being shorted. However, due to the r/wallstreetbets Reddit group and their aggressive call option buying, the price was increased, forcing these traders to be short squeezed.

This, in turn, caused a gamma squeeze due to the large amount of call options bought and the short squeeze causing the price to go up drastically. This led to GameStop’s share price rising by over 1000%.

Other companies that have seen gamma squeezes include Tesla, Tilray, and Beyond Meat.

How to trade a gamma squeeze

To trade gamma squeezes, you must have a high tolerance for risk. Due to the complexities of each situation, no two gamma squeezes are the same. Some will show through very sharp peaks and price changes while others will peter out over weeks.

The main key to trading a gamma squeeze is timing. Because of the speed at which a gamma squeeze unfolds, if a trader cannot identify and trade the situation fast enough, they will lose out. Having a fast and responsive trading platform is vital as well.

There are two factors of a gamma squeeze that you should look out for:

• High short-stock interest: for a squeeze to occur you need to have traders who become stuck. The most common type of trader who gets stuck is a stubborn short trader
• Options activity: options are another vital part of a gamma squeeze. With traders playing in options, there is less market maker movement. Therefore, there are fewer positions to squeeze

Steps to trade a gamma squeeze

1. Create an account or log in
2. Research the market you want to trade
3. Carry out your own analysis
4. Take steps to manage your risk
5. Open, monitor and close your position

Gamma squeezes summed up

• A gamma squeeze is caused by high trading volumes in one direction over a short space of time. These volumes cause the market maker to close out their positions, leading to a spike in the share price known as a gamma squeeze
• While similar to a short squeeze, a gamma squeeze is caused by the market maker while a short squeeze is caused by a trader
• Traders can trade a gamma squeeze by identifying the events leading up to it and reacting quickly when the moment arises
• AMC and GameStop are both great examples of gamma squeezes