To trade stocks successfully, you have to understand a lot of terminology and strategies. Discover what a gamma squeeze is and how it should affect your strategy.
A gamma squeeze is an extreme type of a squeeze, which refers to when investors feel pushed or squeezed to buy or sell a stock they wouldn't normally. They do so to minimize losses. The June 2021 AMC gains illustrate a recent example of a gamma squeeze.
Learn more about what a gamma squeeze is and what you should do as an investor if you are facing one.
What Is a Gamma Squeeze in the Stock Market?
If you are not familiar with them, a gamma squeeze can lead to losses. It can be especially challenging for those who are new to trading. To help yourself with future investments, learn what a gamma squeeze is and how it works and what to do about it.
What Is a Gamma Squeeze vs Short Squeeze?
One of the best ways to explain a gamma squeeze is to compare it to a short squeeze. Squeezes happen if the stock prices come under pressure, typically unexpectedly. The term squeeze comes from the fact that investors who own shares of the stock may feel pressured or squeezed to change their positions due to the rapid price changes.
A short squeeze is just one example of a squeeze. It affects people who shorted the stock. When you short a stock, you bet that the price will drop rather than rise. With a short squeeze, investors who shorted the stock are forced to buy their shares back thanks to the increase in price. Short squeezes frequently increase the stock prices even further. Many times, however, the increase is short-lived.
How Gamma Squeezes Relate to Short Squeezes
If there are a lot of short-dated call options for a stock and they are bought widely, this can lead to a gamma squeeze. This creates a cycle of the price moving upward in a spiral. The call buying increases the stock prices. As the prices rise, more people call buy. That increase in call buying increases the stock prices. This repeats.
Gamma vs. Short Squeezes
While you can use short squeezes to understand gamma squeezes, there is also a very important difference. Short squeezes are caused by traders, while gamma squeezes are because of the market maker.
Specifically, market makers have to exit their trades due to large trading volumes and erratic price movements with a gamma squeeze. This spikes the price. By contrast, short squeezes happen on a smaller scale.
Understanding Gamma Squeezes and the Greeks
The term gamma comes from the Greeks. When an investor refers to the Greeks, they are describing a set of terms to describe trading positions. Delta is another. It refers to how the rate of change for an option compares to the rate of change for the underlying stock price.
Gamma and delta are related. Specifically, gamma measures how the delta changes while the price of the stock moves up or down.
What Is A Gamma Squeeze In Stocks – How It Works
Another good way to understand a gamma squeeze is to look at how it works. The process has to start with investors assuming that the stock's price will rise. When this happens, they short-dated call options of the stock but on a large scale. If the stock's value increases, so does the value of the call option. This means that institutional investors who sell the option in question are in a short position.
The pattern continues. Over time, investors invest in more call positions. This, in turn, forces institutional investors to purchase more stock shares. They have to do so to hedge against their short position.
Even with these conditions, a gamma squeeze is not certain. The conditions have to be met, and then the price of the underlying stock increases quickly in a short time. More money is spent on call options. This increases the buying activity. That, in turn, increases the stock prices.
Understanding Gamma Squeezes In Terms Of Market Makers
Another way to understand gamma squeezes is by doing so in relation to market makers. Remember that whenever investors buy or sell an option, the market maker needs to be able to provide the asset in question at the given price when the trader redeems the option. This is a large risk, and market makers frequently take large positions to counter that risk.
But if traders buy or sell a large volume of an asset, the market maker may need to sell or buy out their positions. When the market makers do so, the price of the underlying shares rises.
Who Wins and Who Loses
With a gamma squeeze, there is profit potential. But this only applies to those who bought call options and then sold them when the prices were high. By contrast, the institutional investors who had short positions and had to cover them can experience significant losses.
Causes of Gamma Squeezes
Now that you have a better understanding of what a gamma squeeze is, what causes it? Technically, a gamma squeeze can happen anytime a stock has large trading volumes in a single direction in a short time. When this happens, market makers have to close their positions.
One of the biggest potential causes of a gamma squeeze is widespread speculation about the stock's future price. One example of this would be in the case of a stock for a financially struggling company. The institutional investors may short the stock because they think prices will drop. That step alone is fairly common. But the other part of the gamma squeeze is very unusual. This is when either a large institutional investor or a group of investors buy the stock. That would lead to a short squeeze.
AMC and GME as Examples
Some very good examples of this situation come from AMC (AMC Entertainment Holdings) and GME (GameStop Corp.) in 2021. Looking at GME, in particular, there were a lot of retail investors who coordinated to buy GME stock. That increase in purchases of the stock increased the price by over 400% at one point. This was good for those investors, but there were also a lot of hedge funds with short GME positions. Those companies had opened short positions because they thought GME's long-term financial outlook was poor.
Once the prices rose, they started making headlines. This led to more people buying GME and the price increasing more. The market makers then had to buy shares, further increasing prices. Eventually, hedge funds that had shorted the stock had to close their positions. Many lost billions.
World news is the other significant factor that can cause a gamma squeeze. Breaking news frequently leads to trade volumes in a certain direction that are higher than normal.
Gamma Squeezes Can Be Risky but Rewarding
As the GME and AMC examples show, a gamma squeeze can lead to significant losses or significant rewards. It is a risky opportunity for investors.
Timing Is Crucial
Timing becomes a crucial part of whether an investor does well or loses a lot from a gamma squeeze. This is especially important because gamma squeezes tend to fizzle out quickly, even after lasting days or weeks. It's important to remember that gamma squeezes will not last in the long term.
Simply put, as soon as the gamma squeeze hits its peak, the price reversals tend to be very fast. This leads to the stock prices dropping very quickly. That obviously comes with a lot of risk. This is one of the reasons the average investor should think twice before trading options. Or, at the very least, you should be willing to lose everything you invest in them.
Should You Invest During a Gamma Squeeze?
If you are not an experienced investor, it is best to just leave the stock involved in the gamma squeeze alone. Remember that the price can peak and drop incredibly quickly. On top of that, prices tend to be incredibly volatile both before and after the gamma squeeze.
If you are risk-averse or not very experienced in trading stocks or options, it is best to just avoid that stock until the squeeze is done. When the squeeze has finished, evaluate the stock like you would any other potential investment.
If You Decide to Invest in Gamma Squeezes…
If you do decide to take the risk and invest in gamma squeezes, make sure you have a fast, responsive trading platform. This will let you make the most of the timing. To find potential gamma squeeze opportunities, look for high interest in short stocks, specifically traders who get stuck in short po
sitions. You should also look at the options activity.
A gamma squeeze occurs when investors have a lot of short positions of a stock open and the stock rises suddenly and quickly. The market makers or institutional investors with the short positions are forced to sell their stocks to reduce losses. This drives the price up even more. Gamma squeezes have a high potential for profits, but they are also extremely risky and can lead to significant losses. Only invest in them if you understand what you are doing and can afford to lose your investment.
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Shawn Manaher is a former financial advisor, has founded 5 online businesses, and is a coach, speaker, podcast host, and author. He's been featured on Forbes, The Consults Corner on TAE Radio, The Writing Biz, What's Your Story, and more.