How a Gamma Squeeze Works

2022-05-20 | Sam Shames

When actively trading in the market, serious traders love to see a solid short squeeze to trade. But, have you ever wondered if there are other squeezes that traders can look for in the market? And the answer to that question is yes, and it’s known as a gamma squeeze. A gamma squeeze is a sudden rapid, significant price movement in a stock that resembles a short squeeze, but it occurs under different conditions.

The conditions that form a gamma squeeze are when traders start up a series of weekly out-of-the-money (OTM) call buying within the options market. When stocks are undergoing a massive amount of traders buying OTM options, that type of activity will create a rare series of events that will quickly make the stock price rise. So, let’s dive into the mechanics of a gamma squeeze and how to spot one.

What is a Gamma Squeeze?

In options trading, there is always a buyer and a seller. But, when it comes to a gamma squeeze there is a certain type of options that get bought. For example, a trader buys a call option in XYZ. The dealer who sold you the call is now short Delta in the stock, but dealers are required to be Delta Neutral, so they must buy XYZ stock to cover the sold options. The gamma squeeze takes things much further than an ordinary OTM call buying process; it occurs on a massive scale. 

Either an individual or many individuals have purchased OTM calls, forcing the dealer to buy as many shares of the OTM calls they have sold. The volume of calls and regular stock buying creates rising prices and gamma exposure within that stock. For the dealer, it creates a frenzy of stock buying because of OTM call buying. For instance, the option buyer may have started buying calls at Delta 30. But because of the influx of mass buying, the stock is more expensive, and now the call costs Delta 50, the dealer has to buy more stock to stay Delta Neutral. 

The gamma squeeze creates a brutal cycle for the dealer that they are unable to stop: 

  • OTM Call buying
  • Stock hedging 
  • Stock rising 
  • More OTM call buying
  • More stock hedging at a higher stock price

The dealer’s gamma and delta are dangerously exposed when caught in this type of predicament within the market. The dealer snowballs into losing more and more money after each transaction has occurred. 

Video Guide of a Gamma Squeeze

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Gamma Squeeze vs. Short Squeeze 

A gamma squeeze will look like a short squeeze to the average trader, but there are differences that traders need to understand. A short squeeze is a vertical increase in price because traders are shorting a particular stock chasing it higher. 

A gamma squeeze is a vertical increase due to traders buying OTM call options, which forces dealers to buy that stock. Traders can identify a gamma squeeze by massive weekly call volumes, usually on OTM strikes.   

What OTM calls buying looks like:

  • If Tesla (TSLA) is selling call options at $900, then the buyers would buy at $1000
  • If Apple (AAPL) is selling call options at $150, then the buyers would buy at $160  

The buyers buy OTM call options on a massive scale, creating a momentum ignition. When sophisticated traders start to see a gamma squeeze with a particular position, traders jump on the opportunity and try to ride the wave. Dealers are essentially powerless in the case of a gamma squeeze; unfortunately, the dealers have to keep buying the stocks as more and more OTM calls are being purchased.

Gamma Squeeze Example

The gamma squeeze is a rare phenomenon; it’s not a regular occurrence within the market. It’s usually a carefully calculated act that involves either a very wealthy individual or a massive community of motivated traders who are all on the same page. Rarely do gamma squeezes happen on accident under normal operating circumstances. However, it’s an extraordinary event that creates headlines and controversy when they happen. Two stocks in recent history have achieved successful results that will go down as the greatest gamma squeezes in history.

GameStop (GME)

GameStop once reigned supreme as the nation’s top video game retailer. But because of advancements in technology and changes in consumer spending, GameStop was soon overtaken by its online competitors. Consumers can now buy video games with their preferred game system and get the games they desire, easier, faster, and cheaper. 

Unfortunately for GameStop, their business model was outdated. For years, their stock steadily declined, making them vulnerable to being shorted by traders and investors who could easily predict the stock would fall. Shorting GameStop was a safe bet, and many traders saw it as easy money, but 2021 happened.

GME gamma Squeeze
Above in the chart for GameStop, you can see a classic example of what a gamma squeeze is and how it occurred. The traders responsible for this massive vertical spike were a Reddit community that poured enormous amounts of money into OTM calls, forcing dealers to buy GME shares of the once declining stock. The gamma squeeze caused mass attention within the trading community, where everyone wanted a piece of the action. However, as you can see in the chart above, the gamma squeeze was short-lived. Traders need to be aware that although gamma squeezes are fun to watch and see, they can be a money pit and should be cautious trading these stocks under gamma squeeze conditions.

AMC (AMC Stock)

AMC is another company that has been negatively affected by technology and consumer spending changes. However, AMC was also heavily impacted by a worldwide pandemic that caused financial hardship, which was already struggling under normal circumstances. Like GameStop, AMC fell victim to traders who relentlessly shorted the stock because of their outdated business model. Traders who enjoyed gains from shorting AMC found their day of reckoning by the Reddit community in 2021.

AMC Gamma Squeeze

In the chart above, the AMC stock rose to uncharted gains within the stock market that the company has ever experienced. But, like GameStop, AMC was going through a gamma squeeze due to the Reddit community buying many OTM calls. Those OTM calls forced the dealer to buy AMC stock at an alarming rate that got considerably more expensive. However, just like GameStop, the gamma squeeze was short-lived. While a gamma squeeze is ongoing, trading is risky, and one should be cautious about getting into the action.

Gamma squeezes are not a regular part of trading. They happen so infrequently that it would be better if traders stick with their trading plans. However, if you have stumbled upon an opportunity, be sure that you recognize it correctly and not mistake it for being a short squeeze. The most significant separation between the two is that short squeezes often occur, while gamma squeezes have a more mechanical operation that is needed to work.

The market is a risky and unpredictable entity, and setups like the gamma squeeze can hurt traders’ portfolios if they are on the wrong side of the trade. However, that’s why Simpler Trading has introduced my “This Week in the Markets” report. My report gives traders my research on the market. I provide an overview of the markets, forecast asset directions, scans of promising tickers and signals, and my list of sectors to focus on each week.

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FAQs on the Gamma Squeeze

Q: What is a Gamma Squeeze and how does it affect stock prices?

A: A gamma squeeze happens when there’s a lot of volume buying OTM call options on a stock in a short time frame, meaning too much of the market is on one side of the trade, which forces the market makers selling those calls to then buy the stock to close out their position. This results in the stock price rising very quickly.

Q: What to consider before buying options?

A: Before you buy options, make sure you understand how they work, have a brokerage account, make a trading plan. Learn when to use a put and when to use a call option. You should also learn put vertical spreads and call vertical spreads. Open a brokerage account with a well-known broker, like TD Ameritrade, which has a great charting platform. Make sure you have a trading plan – most traders fail because they go into trading without a plan for entering, exiting, and managing trades.

Q: What is a Short Squeeze?

A: A short squeeze is when traders and investors betting on a stock going down have to get out of there position by purchasing the stock, sending the price of the stock higher, making it more costly for short positions to exit. A short squeeze occurs when the short float is high and a positive catalyst causes the stock price to rise. That’s when shorts start to cover their positions.

Q: What caused AMC squeeze?

A: Positive news on a stock with a high short float or short interest can cause the stock to explode higher because of a short squeeze. Traders and investors that were shorting the stock (betting on it going down) have to get out of their positions by purchasing the stock back, which causes the stock to go even higher with the added buying volume. AMC had a short squeeze when good news hit the stock and shorts were forced to cover their position by purchasing AMC stock.

Q: How long does a gamma squeeze last?

A: Gamma squeezes don’t have a set or expected length; usually they go week to week based on weekly call volume. The Softbank gamma squeeze lasted for a few weeks when call volume rose very quickly.

Q: What is a gamma squeeze in crypto?

A: Gamma squeezes happen in the options market.

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