A gamma squeeze happens when options market makers are forced to buy (or sell) more of an underlying asset due to large price moves, creating a loop that drives the price even higher (or lower).
For example, when there is significant buying of call options, market makers must hedge by buying the underlying asset to offset their exposure.
As the price of the underlying asset rises, the delta of the call options increases, requiring market makers to buy even more of the underlying asset to maintain their hedge.
This creates a feedback loop where rising prices lead to more buying, which further drives up the price.
The rapid increase in buying activity can lead to a sharp and sustained rise in the price of the underlying asset—this is the gamma squeeze.
Here’s a breakdown of the concept:
Key Elements of a Gamma Squeeze
Options Trading
Options are financial derivatives that give the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price before a certain date.
There are two types of options: calls (which give the right to buy) and puts (which give the right to sell).
Delta and Gamma
Delta measures the sensitivity of an option’s price to changes in the price of the underlying asset. For example, a delta of 0.5 means the option’s price will change by $0.50 for every $1 move in the underlying asset.
Gamma measures the rate of change of delta with respect to changes in the underlying asset’s price. A higher gamma means the delta is more sensitive to price changes in the underlying asset.
Market Makers and Hedging
Market makers are entities that provide liquidity in the options market by buying and selling options.
To manage their risk, market makers often hedge their positions by buying or selling the underlying asset.
How a Gamma Squeeze Unfolds
1. Large Directional Move
The underlying asset makes a significant move, either upward or downward. This move can be triggered by various factors such as news events, earnings reports, or market sentiment.
2. Positive Gamma Exposure
As the underlying asset moves closer to the strike price of the options that were previously sold or shorted, these options gain positive gamma exposure.
Positive gamma means that the delta of the options increases as the underlying asset price moves in the same direction.
3. Increasing Delta
With positive gamma, as the underlying asset continues to move in the same direction, the delta of the options keeps increasing. Delta measures the sensitivity of an option’s price to changes in the price of the underlying asset.
4. Hedging Delta Exposure
To hedge this increasing delta exposure, options sellers, including market makers, are forced to buy more of the underlying asset if the price is rising (or sell more if the price is falling). This hedging activity is necessary to maintain a neutral position and manage risk.
5. Self-Reinforcing Loop
The buying (or selling) pressure on the underlying asset from the options sellers’ hedging activities further fuels the initial move.
This additional buying (or selling) drives the price higher (or lower), which in turn increases the gamma exposure even more.
This creates a self-reinforcing loop where hedge buying drives up the price, increasing gamma, requiring more buying, and so on.
This loop can cause the asset price to “squeeze” significantly higher or lower than what fundamentals alone would suggest.
Example of a Gamma Squeeze
Suppose a stock is trading at $10, and there is a surge in buying call options with a strike price of $11.
As the stock price starts to move up due to demand for the calls, market makers begin to buy the stock to hedge their short call positions.
As the stock price rises to $10.50, the delta of the call options increases, prompting market makers to buy even more stock.
This can lead to a rapid increase in the stock’s price, potentially pushing it well beyond the $11 strike price.
Summary
A gamma squeeze is a phenomenon where positive gamma forces options market makers to aggressively buy (or sell) more delta hedge as the underlying asset trends in one direction.
This can lead to rapid and exaggerated price movements, making the asset’s price deviate significantly from its fundamentals.
Understanding the mechanics of gamma and delta, and the importance of hedging by market makers, is important for traders to navigate these potentially volatile market conditions.