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Trading Terms

Gamma squeeze: what is it and its effects?

Gamma squeeze: A trading chart showcasing gamma squeeze.

Investing in the stock market is almost like embarking on an unpredictable river journey. Just as a river's currents can shift, so too can market conditions, presenting opportunities and challenges in equal measure. 

One such phenomenon that can cause (and has previously caused) significant ripples among investors and traders is the gamma squeeze. 

This article will focus on explaining what a gamma squeeze is, the causes and effects of such events and the opportunities and risks it may present. 

What is a gamma squeeze and what causes it?

A gamma squeeze is a rapid and significant increase in a stock's price, usually triggered by large trading volumes in one direction within a short span of time. This event typically starts when many investors buy call options for a certain stock.

Call options are contracts that give the buyer the right (but not the obligation) to buy a stock at a set price before the option expires. Market makers, who facilitate the trading of these options, hedge their risk by buying the underlying stock.

When a large volume of call options are bought, market makers are compelled to buy more of the underlying stock to hedge their position, which can drive the stock price up. As the price increases, more call options move "into the money" (meaning it becomes profitable to exercise them), causing further buying of the stock by market makers.

This cycle can lead to a very sharp increase in the stock's price, known as a gamma squeeze. It's important to note that a gamma squeeze is not a form of market manipulation but a natural function of market participants hedging against options positions.

However, it’s important to note that gamma squeezes can be unpredictable and risky, often attracting more speculative traders.

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Gamma squeeze vs short squeeze: differences?

While they may seem similar, gamma squeezes and short squeezes are distinct events. A short squeeze involves a stock with a high degree of short interest, where short sellers are compelled to cover their positions as prices rise, driving the price even higher.

In contrast, a gamma squeeze revolves around options and the market makers’ need to hedge their positions. It’s driven by the technical dynamics of options rather than the direct supply and demand of the stock itself.

How do gamma squeezes work in stock trading?

A gamma squeeze in stock trading happens when there's a rapid increase in the price of an underlying stock within a short period of time. This usually occurs due to significant options buying in a single security, leading to changes in dealer hedging that further pushes the stock prices up.

In simpler terms, a gamma squeeze starts when many investors buy call options for a certain stock. A call option is a contract that gives the buyer the right (but not the obligation) to buy a stock at a set price before the option expires. Market makers, who facilitate the trading of these options, typically hedge their risk by buying the underlying stock.

When a large volume of call options are bought, market makers need to buy more of the underlying stock to hedge their position. This surge in buying can drive the stock price up. As the price increases, more and more of the call options move "into the money" (meaning it becomes profitable to exercise them), which can lead to further buying of the stock by market makers and an even higher stock price.

This cycle can lead to a very sharp, vertical increase in the stock's price—the gamma squeeze. It's important to note that a gamma squeeze is not a form of market manipulation, but a natural function of market participants hedging against options positions.

Examples of gamma squeeze

  1. GameStop in 2021: One of the most famous recent examples of a gamma squeeze was with GameStop's stock in January 20211. A large number of retail investors, from the Reddit and WallStreetBets forums, bought call options on GameStop stocks, causing market makers to buy more shares to hedge their positions. This led to a rapid increase in the price of GameStop's stock, a classic example of a gamma squeeze.

  2. SoftBank in 2020: SoftBank, a Japanese technology investment company, earned the nickname "Nasdaq Whale" after its heavy buying of tech stock options in the US market caused significant price movements. This substantial options activity forced market makers to buy large amounts of the underlying stocks to hedge their positions, resulting in a gamma squeeze.

How to trade a gamma squeeze

Trading a gamma squeeze involves ample risk and requires accurate timing due to its rapid unfolding. No two gamma squeezes are alike; they vary in their intensities and durations. 

Two factors to note when anticipating a gamma squeeze are:

  • High short-stock interest: For a squeeze to occur, you ideally have traders 'stuck' in a position—often, these are short sellers who have bet against a stock and are reluctant to exit their positions.
  • Options activity: Significant options activity is also crucial. The less movement by market makers due to their hedging, the fewer opportunities to squeeze.

Steps to trade a gamma squeeze:

  1. Research the market you intend to trade: Stay informed about market conditions, news, and stock performance.
  2. Carry out your own analysis: Use technical and fundamental analysis to identify potential gamma squeeze opportunities.
  3. Use proper risk management: Set up stop-loss orders and only allocate a portion of your portfolio to these high-risk trades.
  4. Open, monitor, and close your position: Timing in opening and closing the trade is crucial; be ready to act fast.

Summary

As you've seen, a gamma squeeze can be a formidable market force, propelling stock prices to unexpected heights. Understanding the mechanics behind it—notably the role of market makers and the power of collective trading volume—is key for savvy traders and investors. While the allure of a gamma squeeze can be strong, always assess your risk tolerance and be prepared for rapid market shifts.

FAQs

1. What is a gamma squeeze?

A gamma squeeze is a rapid increase in a stock's price due to significant options buying activity. This leads to changes in dealer hedging that further pushes the stock prices up.

2. How does a gamma squeeze occur?

A gamma squeeze starts when many investors buy call options for a certain stock. Market makers, who facilitate the trading of these options, typically hedge their risk by buying the underlying stock. When a large volume of call options are bought, market makers need to buy more of the underlying stock to hedge their position. This surge in buying can drive the stock price up.

Yes, a gamma squeeze is legal. It isn't a form of market manipulation but a natural function of market participants adjusting their positions based on option trading activity.

4. Can a gamma squeeze be predicted?

While it's difficult to predict a gamma squeeze with absolute certainty, certain signs can indicate the possibility of one. These include a high amount of call option buying and a large short interest in a stock.

5. What is an example of a gamma squeeze?

One of the most famous recent examples of a gamma squeeze was with GameStop's stock in January 2021. A large number of retail investors, many from the Reddit forum / WallStreetBets, bought call options on GameStop stocks, causing a rapid increase in the price of GameStop's stock.

Past performance does not guarantee or predict future performance. This article is offered for general information and does not constitute investment advice. Please be informed that currently, Skilling is only offering CFDs.

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