How a Gamma Squeeze Actually Works

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.

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