What Is a Gamma Squeeze?

In investing, rapid changes in the price of assets – particularly stocks – occur all the time. When this happens, investors feel the “squeeze” and enter or exit positions outside of their normal trading patterns. These are common features of the derivatives market that can come in the form of a gamma or short squeeze.    

So, what is a gamma squeeze, and how exactly is it different from a conventional squeeze? The latter is more common and refers to instances when investors who sold their stock short due to rising prices are trying to buy back those shares. A gamma squeeze is a more extreme version, which leads to additional stock-buying activity and further price hikes.   

Gamma Squeeze Explained

Traders do not buy and sell options to individual investors. Instead, they trade with a market maker – a participant in an exchange that buys and sells securities for their own account. 

As with other market participants, the goal of the market maker is to generate a profit. When pricing options, they use the Black-Scholes-Merton pricing equation – a formula that allows them to estimate option value given current market conditions.

During a gamma squeeze, the price of stocks changes considerably. In many cases, investors need to change their positions. There is a flurry of activity on the derivatives market. Market participants buy short-dated call options of the affected stock, increasing demand.

This process then increases the price even more, encouraging additional investors to pile in and buy the stock.

Call Options

Now that we’ve covered the gamma squeeze meaning, let’s look closer at the conditions under which gamma squeezes occur. Here it’s important to touch on call options.

A call option is a financial contract giving market participants the right to buy a financial asset (such as a bond or stock) at a specified price within a given period of time. 

For instance, suppose that a call option contract gives the buyer the right to purchase 1,000 shares of Google for $2,000 each, with the offer expiring within three months. If the price of Google shares rises in that time, so too does the price of the options contract.

That’s because anyone buying the contract gets the right to purchase Google shares at a discount and then sell them for a higher price to the market. 

Rising prices put sellers – usually institutional market markers – in a tough position. Market participants are essentially forcing them to short stocks because the value they are quoting for the stock in the option contract is lower than the market price. Investors are forced to cover their losses, and eventually, a gamma squeeze occurs.

What is Delta, And How Does it Relate to Gamma? 

Delta is the ratio that compares the change in the price of the asset to the change in the price of the underlying option. Values for delta range from 1.0 to -1.0. 

• For call options, values are between 0 and 1.0 because as the value of the asset rises, so too does the value of the call option
• For put options, delta ratios run from -1.0 to 0 because as the value of the asset rises, the value of the put option falls.

Delta allows investors to measure risk. Unfortunately, it has limitations. It’s only valid for the narrow range around the current price level, and it cannot tell you how changes in asset prices will affect underlying value options. 

Meanwhile, a closer look at how a gamma squeeze works reveals that it can tell investors how delta is likely to change as asset prices change. If gamma is zero, it means that delta is linear and investors can extrapolate it in either direction. However, if delta is greater or less than zero, it indicates that options value sensitivity will change as the price changes. 

Gamma squeezes occur when the rate of delta change accelerates. Small changes in the underlying asset price can force wild swings in call and put option values because of investor expectations of where prices are likely to head in the future. 

Has a Gamma Squeeze Ever Happened? 

The answer to this question is yes. Gamma squeezes typically occur during periods of widespread speculation about a stock’s value. For instance, during the Gamestop saga in January 2021, large institutional investors began buying the company’s shares, perhaps because its associated metrics looked favorable for their investment objectives. 

As the video game retailer attracted the attention of other investors, demand for its call options rose further. This, in turn, led to a rise in the price of the company’s stocks and increased short squeeze activity. At one point, the stock price of the video game retailer rose by more than 400%. 

While some investors saw massive profits as a result of this squeeze, many suffered billions in losses. 

Do Gamma Squeezes Last a Long Time? 

Gamma squeezes do not typically last a long time. In many cases, they only last a few hours, perhaps a couple of days at the most, before the market stabilizes. 

The aforementioned Gamestop gamma squeeze example is an outlier. Prices continued to rise for weeks before finally reaching a peak.

However, just like other similar events, prices fell swiftly after that peak. Everyone who had speculated on rising prices attempted to exit their positions to avoid losses. This led to a reverse gamma squeeze. 

As such, trying to take advantage of a gamma squeeze is extremely risky. You could potentially make a lot of money, but you may also experience immeasurable losses. 

How to Trade a Gamma Squeeze

If you want an example of a gamma squeeze, you don’t have to look far. Beyond Meat, Tilray and Tesla stocks have all experienced them. 

If you want to trade a gamma squeeze, you must be prepared to accept a high degree of risk. Each gamma squeeze differs from the last, and you can’t always predict which direction the stock will go. 

To be effective, you will need to use a high-speed trading platform. The smallest mishap can make the difference between generating a sizable profit and major losses.

You will also need to follow conditions for a gamma squeeze to apply: 

• Stubborn, short traders in the market – those who hang onto their positions, despite rising prices
• The presence of market markers
• The existence of a short call options market
• Unexpected news about the rising price of a stock

Wrapping Up

A gamma squeeze occurs during high trading volumes over a short period of time. Large volumes cause market makers to close out their positions, leading to a spike in share prices. Unlike short squeezes, which affect regular investors, gamma squeezes cause the market maker to lose.