How a Gamma Squeeze Actually Works

June 9, 2021

By: Wayne Duggan

So-called “meme” stocks like AMC Entertainment (NYSE: AMC) and GameStop (NYSE: GME) have skyrocketed in 2021. Groups of retail traders on Reddit and other social media platforms have rallied behind these stocks, orchestrating targeted buying campaigns aimed at forcing short-sellers out of their positions.

One contributing factor to the extreme price moves in these stocks has been a market phenomenon known as a gamma squeeze. Here’s how it works.

It Starts with Option Buying
When a trader buys an option contract, it is typically bought from a market maker, such as Citadel Securities.

When a market maker like Citadel sells an option contract, it is selling it at a price at which it expects to make a profit on the deal. Market makers typically use the Black-Scholes options pricing model to determine that price.

Market makers will then determine what they need to do to effectively hedge against that option contract by buying or shorting shares of the underlying stock. This hedging process ensures market makers aren’t exposed to heavy losses in the event the stock moves unexpectedly.

Understanding the Greeks
The Black-Scholes options pricing model includes several different risk variables, which are collectively known as the Greeks. An option contract’s delta represents the expected change in the price of an option contract based on changes in the price of the underlying stock. A call option with a delta of 0.1 is expected to rise in price by about 10 cents for every $1 rise in the underlying stock.

Gamma is a derivative of delta. In mathematical terms, gamma represents the slope of a plot of an option’s delta versus the underlying stock’s price.

A call option contract’s gamma is at its highest as the price of the underlying stock approaches the exercise price of the option contract.

Triggering a Gamma Squeeze
When an individual or entity buys a lot of deeply out-of-the-money call options, the initial gamma on those contracts is relatively low. Therefore, the Black-Scholes model doesn’t require market makers to hedge their net short position with a large net long position in the underlying stock.

However, if the stock price starts to rise significantly toward the option’s exercise price, the option contract’s gamma ramps up quickly, forcing the market maker to buy a large amount of underlying stock to maintain an appropriate hedge. Those large purchases of stock drive the share price even higher, creating a positive feedback loop that generates extreme spikes in the stock’s share price.

This forced buying by market makers is a gamma squeeze. Understanding the basics of a gamma squeeze and what triggers it is an important part of following the crazy trading action of popular meme stocks in 2021.

Disclosure: The author holds no positions in the securities mentioned.

Active Trading with Lightspeed
Lightspeed provides professional traders with all the tools required to help them find success in stock trading, and we have been developing and honing our active trader platform to offer an optimal user experience. With the intuitive interface layouts and institutional quality stock and options scanners, we aim to help traders reach their goals, no matter what their strategy is. We also offer our clients some of the lowest trading fees in the industry.

For more information on a professional trading platform with Lightspeed, please call us at 1-888-577-3123, request a demo or to open an account.

Lightspeed Financial Services Group LLC is not affiliated with these
third-party market commentators/educators or service providers. Data,
information, and material (“content”) are provided for informational and
educational purposes only. This content neither is, nor should be construed as
an offer, solicitation, or recommendation to buy or sell any securities or
contracts. Any investment decisions made by the user through the use of such
content is solely based on the users independent analysis taking into
consideration your financial circumstances, investment objectives, and risk
tolerance. Lightspeed Financial Services Group LLC does not endorse, offer nor
recommend any of the services or commentary provided by any of the market
commentators/educators or service providers and any information used to execute
any trading strategies are solely based on the independent analysis of the user.

You may also be interested in…

Source: https://www.lightspeed.com/active-trading-blog/how-a-gamma-squeeze-actually-works/