Gamma Squeeze Explained: The Options Trick Wall Street Loves to Hate

Imagine a stock skyrocketing 100% in days, leaving Wall Street traders scrambling. Sound familiar? That’s the chaos of a gamma squeeze.

Gamma squeeze occurs when there’s an increased interest in a particular stock leading a large number of traders to buy call options on the stock. This triggers market markers to buy back the underlying stock to hedge their positions, which drives the stock price higher. Call options get closer to being in-the-money, which entices more traders to buy the stock, and the price continues to rise until it eventually drops sharply in value when traders either take the profit or let their options expire as worthless.

Gamma squeeze is a phenomenon that has a dual nature of being lucrative for some traders and a nightmare for those who aren’t aware of what’s occurring. Wall Street has a particularly nuanced opinion on gamma squeeze with some high–risk-tolerance traders loving the opportunity to secure a big profit and others not liking the uncertainty involved with the phenomenon.

Our guide on gamma squeeze will give you a complete breakdown and explanation of this occurrence, how it works, and how it plays out for traders, including those who may or may not know what they’re doing. We’ll also talk about how gamma squeezes impact the markets and provide some real-world examples to give you a clear illustration of how they work.

The Basics—Understanding Options and Gamma

Part of giving you a clear understanding of gamma squeeze is to outline the basic principles at play. First, we’ll run through a quick overview of options trading and how that works, followed by a highlight of what the gamma Greek is and the role it plays in the price of options. Market markers also play a key role in the setup of a gamma squeeze so we’ll touch on that in this portion of the guide as well.

Options 101 Recap

Options are contracts that give traders the right to buy or sell an asset, like a stock, at a specific price (the strike price) by a certain expiration date. When buying an option, the trader is paying a price (the premium) for the right (not the obligation) to buy or sell the asset. It’s preferable to exercise the option if the price of the underlying asset moves favorably for the trader, which results in them buying or selling the asset at the strike price. It’s recommended to not exercise the option if the underlying asset doesn’t move favorably, which results in the option expiring as worthless, with the trader losing the premium they paid to enter the position.

Key Concepts

• Premium: The price the trader pays to enter the options contract.
• Underlying Asset: This refers to the asset that the option contract is based on like a stock, commodity, or index.
• Call Options: These give the trader the right to buy the underlying asset at a strike price.
• Put Options: These give the trader the right to sell the underlying asset at a strike price.
• Strike Price: This is the price at which the underlying asset can be bought or sold in the event that the options contract is exercised.
• Expiration Date: This signifies the date when the option contract expires and becomes worthless if it’s not exercised.

We’d be remiss if we didn’t talk about the concept of “delta” which is the rate of change in option price relative to stock price. This comes into play in the next section where we talk about “gamma” and its special correlation with the “delta” Greek.

What Is Gamma?

Gamma is a measurement of the rate of change in an option’s delta per a 1% change in the underlying asset’s price. Gamma quantifies the sensitivity of an option to price changes and how much it could change for every $1 underlying asset movement. It’s a measure of how fast an option’s sensitivity to the stock price accelerates. In short, gamma is the rate of change in delta.

We already talked about how delta is a measurement of the percentage of change in an option’s price for every 1% change in the underlying asset’s price. Delta has an interesting relationship with gamma in that delta is like the speed of a car, while gamma is the acceleration (the rate of change in that speed).

Gamma matters more as expiration nears because its impact on option pricing becomes significant as the options’ value increasingly reflects the intrinsic value rather than time decay. As the expiration date draws closer, the potential for large or sudden changes in the delta increases.

The importance of gamma also increases significantly when a stock gets closer to the strike price of an option (moving “in the money”) because it measures the rate of change in delta which ultimately decides how quickly the price changes with movements in the underlying stock price.

Market Makers’ Role

Understanding the role of market makers is important when talking about gamma squeezes. Market markers are dealers in a security or other assets who undertake to buy or sell at specified prices at certain times. A lot of the time, market makers are responsible for gamma squeezes occurring in the first place.

When the price for a stock is increasing because there’s a larger volume of traders than usual who want to buy call options on them, market makers will often sell options and hedge by buying/selling the underlying stock. Gamma amplifies its hedging activity, which can spiral into a squeeze.

How a Gamma Squeeze Happens

Learn how gamma squeezes occur as we outline the initial conditions that lay the groundwork for the squeeze to happen, the triggering event that leads to the squeeze, and the chain reaction of what occurs from there. We’ve even outlined how the squeeze peters out with time and where the trader can make some money during the process.

1. The Setup

Gamma squeezes happen when there are heavy buying or call options, which trigger a chain reaction. Market makers end up buying more shares to hedge their positions which pushes the stock price higher. The events that precede gamma squeezes are an atmosphere where there’s high open interest in call options, especially near-the-money or slightly out-of-the-money. Essentially, there’s a lot of interest in the asset’s potential for price increases, which signifies strong liquidity and bullish market sentiment.

Low float or heavily shorted stocks are prime candidates for gamma squeezes. These are stocks with a small number of shares that are available to the trading public. A majority of those shares are held short (they have borrowed shares, sold them, and are betting the price will fall,) which makes them highly prone to volatility and other events like gamma squeezes. Meme stocks, those that gain popularity with retail traders through social media, are particularly prone to gamma squeezes.

2. The Trigger

With the proper conditions in place, there needs to be a trigger that pushes the stock price up and gets the ball rolling for the imminent gamma squeeze. Examples of these catalysts are events like earning reports, rising stock prices, high short interest, coordinated activity on the part of retail traders, or any sort of expected news.

As the call options move in the money (closer to the strike price), the delta increases, making the option’s price more sensitive to changes in the underlying asset’s price. At the same time, gamma increases which signifies the delta experiencing a faster rate of chance as there are price movements in the underlying asset.

Catalysts Explored

– Coordinated Activity By Retail Traders: Gamma squeezes have been known to occur when retail traders get together on social media and put together coordinated trading strategies. This happens quite a bit with meme stocks and, most notably, in 2021 with the GameStop Squeeze.
– High Short Interest: When traders have shorted a stock, they have borrowed shares on the stock, sold them, and are betting the price will fall. Having a large number of traders shorting a certain stock results in a sudden price increase which leads them to cover their positions, leading to the price going up higher.
– Unexpected Market News: The unexpected news that is positive, like a good earnings report or any other kind of event that drives interest in the stock, can lead to a surge in demand, which could possibly lead to a future gamma squeeze.
– Low Liquidity: When there’s a limited amount of an asset and there’s a high demand for it, traders are fighting for what is an illiquid stock, which drives up the price further, which could lead to a gamma squeeze in time.
– Rising Stock Prices: A rising stock price could trigger further buying pressure from the market makers who are interested in hedging their positions, leading to a possible gamma squeeze.
– High Volatility: Demand for options can go up where there’s high volatility in the underlying stock. High volatility can eventually lead to a gamma squeeze.

High Volume of Call Options: When traders are aggressively buying call options near key strike prices, market makers are forced to hedge their positions by buying the underlying stock. A higher-than-usual volume of call options can lead to gamma squeezes down the road.

3. The Chain Reaction

Any one of the catalysts we mentioned above could happen and could lead to a gamma squeeze on certain stocks or assets. But how exactly does it happen? A lot of this comes down to the market makers, the dealers in a security, or other assets who undertake to buy or sell at specified prices at certain times. In many cases, when these catalysts occur, market makers buy stock to hedge their short call positions which leads to pushing prices higher and higher, setting the stage for the gamma squeeze to occur.

So what happens from there? When heavy buying of call options creates a positive feedback loop, which drives up the price of the underlying stock (as the market makers are hedging), increasing the stock price even further. The rising stock price increases gamma, forcing more buying—a feedback loop.

4. The Squeeze Peaks

The gamma squeeze peaks refer to the point where the unsustainable and rapid rise in a stock price reaches its highest point before an imminent, sharp decline. What’s happening is that gamma increases (especially for -the-money options), pushing the prices up to the peak. The self-reinforcing cycle that pushed the gamma squeeze will begin to break down as the price becomes way too high, and speculators will begin exiting their positions.

When the momentum fades, traders will often either take profit on the positions or let the positions expire as worthless if that’s part of their strategy. A bulk of the traders backing out of the position can lead to a sharp decline, breaking the gamma squeeze cycle and feedback loop.

Real-World Examples

Looking at real-world examples of gamma squeezes can bring a lot of what we’ve described in this guide to life. Let’s look at the GameStop Squeeze that happened in 2021 (the one we’ve already mentioned several times) and a similar instance that happened with AMC Entertainment stock during the same year.

GameStop (GME) 2021

The initial catalyst for this 2021 gamma squeeze for GameStop stock occurred when there was a coordinated effort by retail traders from Reddit’s WallStreetBets forum to buy call options on GameStop. The reason for this coordinated effort was to force market makers to buy back their shares. This led to the price going up higher on the stock, creating a gamma squeeze. The stock surged from $20 to $483 in weeks.

Meme stocks are shares of a company that have gained viral popularity due to them being the subject of attention on social media sites like Reddit and others. The meme stock frenzy that the markets saw in early 2021 with GameStop and AMC Entertainment involved retail traders call buying, and short sellers caught in a gamma-driven spiral.

AMC Entertainment (AMC)

The dynamics of this gamma squeeze were similar to what happened with GameStop. There was high call option volume in AMC Entertainment stock and this short interest fueled a gamma squeeze. Due to retail traders heavily buying call options, the market makers were forced (much like the GameStop scenario) to buy even more shares to hedge their positions, which created the feedback loop that encouraged even more trading. Prices soared by more than 100% in a single week in May 2021.

Lessons Learned

In the case of the AMC and GameStop gamma squeezes it was shown how truly vulnerable the institutional investors and smart money traders on Wall Street were to coordinate retail trading and options leverage. This is the best showcase of why Wall Street tends to see gamma squeezes as a big risk instead of any opportunity to make money. The uncertainties around gamma squeeze can lead to significant losses, even for the smart money investors who typically benefit over the typical retail trader.

Why Wall Street Loves to Hate Gamma Squeezes

Wall Street’s feelings toward gamma squeeze are more nuanced than you would think. They don’t definitively love or hate game squeezes but see them as opportunities to profit even if they are unsustainable and can create a lot of uncertainty within the broader market. A lot of market makers and institutional investors see gamma squeezes as too risky to take on in many cases. We’ll break this down a bit further to give you a better understanding of how Wall Street uses gamma squeezes to their advantage, while not actively welcoming or encouraging them.

The Love

• Opportunistic Traders: There are plenty of these on Wall Street, and they see the profit potential in gamma squeezes. However, many of these opportunists have a high-risk tolerance and are willing to take on the risks which can often outweigh the benefits. This kind of trader could simply be a savvy retail trader, or it could be a hedge fund manager, and they’re primarily looking to profit massively from the volatility.
• Options Desks: This term refers to a team or department at a financial institution that specializes in trading or managing options contracts on behalf of the institution. Options desks offer their services to help retail traders or corporations earn extra income. These entities thrive on heightened trading volume, and they see gamma squeezes as a prime opportunity to sell to their customers.

The Hate

• Short Sellers: This refers to the traders who profit from the decline in an asset’s price by borrowing shares, selling them, and buying them back at a lower price to return to the lender. Traditional short sellers get burned as prices defy fundamentals, so a lot of the hate that comes from Wall Street toward gamma squeezes comes from these traders.
• Market Makers: These dealers can face risk management nightmares from rapid hedging, so market makers aren’t the most keen on gamma squeezes, and they generally don’t see them as a good opportunity to profit. They see them more as a risk that isn’t worth it. It makes sense that it’s these traders who buy stock to hedge their short-call positions, which creates the gamma squeeze to begin with.
• Regulatory Scrutiny: Agencies like the US Securities and Exchange Commission (SEC) tend not to like gamma squeezes and how they defy market fundamentals. Following the GameStop squeeze in 2021, the SEC considered making broad changes to curb these frantic buying patterns rooted in social media influence. Events like gamma squeeze create more work for agencies such as this.

A Double-Edged Sword

The market doesn’t like uncertainty. This is a well-known truth when it comes to trading stocks or options. The more certainty there is, the more confidence that investors have in general which leads to low volatility, a lot of open interest, and liquid options. Gamma squeezes are conditions where a stock is about to see a big reversal, and the traders who are aware of gamma squeezes and can spot it coming can feel a lot of uncertainty about the future of the stock because it’s sure to decline in value. Gamma squeezes disrupt the “orderly market” Wall Street prefers, so professional traders tend not to encourage or welcome them.

How Traders Can Spot and Navigate Gamma Squeezes

Gamma squeezes are a market phenomenon that can cost traders money if they don’t see them coming or are unaware of what they are and how they play out. Learn how to spot these occurrences early and navigate them in a way where you aren’t risking a significant amount of your capital on an opportunity that is too good to be true. We’ll outline how to spot the initial signs, how to play the squeeze to lock in a profit, and how to manage risk along the way, no matter what path you decide to take.

Spotting the Signs

To know when a gamma squeeze is on the horizon for a stock, you need to know the primary signs of a gamma squeeze and the conditions that need to be in place for this phenomenon to play out. You can either use these signs to avoid getting into trades where there could be a gamma squeeze on the stock or the underlying asset that the contract is pegged to or to find opportunities where you could try to secure a profit from that stock as the value continually rises from increased interest.

• High Options Open Interest: It’s best to look for stocks where there’s a high number of outstanding call option contracts. The key is that these are stocks with high open interest relative to stock float and those with shorter expiration dates. When the stocks are in this state, it can create a buying force that is well-concentrated when there’s a rise in the stock price.
• Rising Implied Volatility: When stocks are experiencing a gamma squeeze, they tend to experience a higher level of volatility. This manifests within a short period as sharp price movements. A sharp rise in implied volatility is one of the telltale signs of a gamma squeeze in the making.
• Rising Gamma Exposure: This can be seen when there’s a price surge in the underlying asset through a sharp spike in call option volume or open interest. It’s most common with OTM options and in situations where there’s a lack of good reasons for the stock to rise. Check options chains or “gamma exposure” data, if available, to find out where the current level of gamma exposure might be.
• Social Media or News Buzz: These sources can be used as a sentiment indicator to pinpoint when a gamma squeeze could be on the horizon for a particular stock or underlying asset. If there’s a stock that’s really been hyped up and there are plenty of retail traders showing interest in buying call options on those stocks, that’s a great sign of a gamma squeeze coming up. There’s no greater example than the GameStop squeeze, which happened because of coordinated trading activity that was organized on Reddit.

Playing the Squeeze

If you’re someone who has a high-risk tolerance and you want to take a crack at profiting from a gamma squeeze play, here are a few tips to play your cards right and lock in profit before the gamma squeeze peak gets the best of you.

• Buying Calls Early: To increase the likelihood of profiting from a gamma squeeze, buy the call options early on. While it’s a risky maneuver, it can be a high-reward move that secures a tidy profit, so long as you get out of the trade before the severe stock price drop occurs.
• Avoiding the Peak: The key to profiting from a gamma squeeze is to time your entry early when the hype around the stock is first getting underway, but then it’s a matter of timing your exit to avoid the peak where the price is going to fall off drastically. You can get a good gauge of when to take the profit right before the peak by using technical indicators like RSI or volume spikes.

Risk Management

We’d be remiss if we didn’t go over a few general risk management techniques that will greatly benefit your overall experience dealing with gamma squeezes. Learn about the risk management systems you should have in place and some of the effective tools for guarding yourself if you’re committing to making a profit from a gamma squeeze.

• Warning About Volatility: Gamma squeeze can lead to rapid and unpredictable price movements. Volatility can cause prices to crash as fast as they rise post-expiration, which is why gamma squeezes are well-known for the potential for significant gains or losses. Not only do you have the volatility associated with the stock price spiking up, but you also have the volatility that comes when a ton of traders exit their positions, causing the stock’s value to plummet.
• Use Stop-Losses: Another helpful way to mitigate your losses around a gamma squeeze move is to have stop-loss orders in a place where you can exit a trade automatically when there’s a significant drop in the value of the stock price. This can be helpful in a scenario where you’re trying to profit from a gamma squeeze but it goes south.
• Used Defined-Risk Strategies: Traders can use strategies like spreads to successfully profit around gamma squeezes and to keep their potential losses to a minimum. It involves identifying stocks that have high call option buying activity and then using a move like a calendar spread where you would sell a call option with an earlier expiration date and buy a call option with a later expiration date to take advantage of the time decay on the shorter-dated option.

The Future of Gamma Squeezes

Gamma squeeze was never really studied or considered with the care that it does now until after the GameStop squeeze happened. Now that retail traders understand the power they wield through coordination on social media or other platforms, what does the future look like for the gamma squeeze move? Will we see more of these happening in the future? We’ve offered a few of our speculations below for your convenience.

Retail Trading’s Rise

Retail trading refers to options or stock trading that is done by the average, everyday person. This is a stark difference from institutional traders or market makers who execute large orders and work on behalf of banks, venture capital funds, insurance companies, or hedge funds. Retail traders deal with much smaller volumes, primarily due to much less available capital.

Trading apps like Robinhood are designed with retail traders in mind and offer a simpler approach to trading that works well for newcomers or those who have a decent amount of trading experience and want to take things to the intermediate level. Robinhood makes options trading more accessible to the ordinary, average person, which can empower moments in the markets where there are gamma squeezes.

In addition to accessible trading platforms like Robinhood, social media platforms are another place where traders can gain knowledge of trading techniques or phenomena like gamma squeezes. Sites like Reddit, in particular, can teach newer investors about these tricks and market hacks which ultimately empower them to put market makers in a position where they must buy additional shares to hedge their positions, raising the stock price in the favor of the retail investors.

Regulatory Wildcard

While there aren’t any specific regulations right now on options trading practices that could lead to gamma squeezes, regulatory bodies like the US Securities and Exchange Commission (SEC) regularly monitor the market for signs of manipulation or risks to market stability. They can intervene if need be, and there are speculations on potential crackdowns on options trading or short-selling rules, especially following the GameStop squeeze in 2021. However, it’s unlikely as squeezes are simply a natural outcome of the market dynamics involved in options trading.

Speculation

It’s hard to say right now if gamma squeezes will become more frequent as markets democratize. Gamma squeeze occurs more often when trading stocks that have a bearish outlook or those that are used in shorter trades, so these are the prime times to be looking out for them. It’s theoretically possible that as more retail traders are able to access the market, you’ll see more of these squeezes occurring, but if that was true, we would have seen a lot more of them in the last four years.

Gamma Squeezes: Chaos Conquered

Gamma squeezes are a potent mix of options mechanics and human behavior. When there’s an influx of retail interest in a stock, market makers can’t help but buy more call options to hedge their position which just encourages more retail buying, inflating the price unrealistically. That bubble will be ready to burst at any moment, so it’s important to know how to navigate this occurrence if you realize what you’re in the midst of. Squeezes can best be described as a trader’s dream and a traditionalist’s nightmare. Understanding them is key to thriving in modern markets.

The key to successfully trading around a gamma squeeze is to enter early in the process. You can pinpoint a squeeze when observing the following signs:

• A lack of fundamental reasons for the stock to rise
• A sharp increase in the volume of call options
• Active hedging purchases by market makers

Entering the makings of a gamma squeeze early gives you the time you need to secure your profit as the stock price continues to rise through the feedback loop (you can also use these signs to avoid getting involved in the squeeze altogether). You can get a good gauge of when to take the profit right before the peak by using technical indicators like RSI or volume spikes.

Explore more resources on options strategies for more information, and feel free to share any gamma squeeze experiences you might have had in the past below in the comments.