Gamma squeeze: Meaning, Criticisms & Real-World Uses

Gamma Squeeze

A gamma squeeze is a rapid and significant upward movement in a stock's price, often triggered by a surge in demand for short-dated call options on that stock. This phenomenon falls under the broader category of derivatives trading and options market dynamics. It compels market makers to buy the underlying asset to hedging their positions, creating a self-reinforcing cycle of buying pressure that drives the stock price higher. The term "gamma" refers to one of the "Greeks" in options pricing, which measures the rate of change of an option's delta.

History and Origin

While the underlying mechanics of options market maker hedging have existed for as long as options have been traded, the concept of a "gamma squeeze" gained widespread public attention during the "meme stock" phenomenon of early 2021. During this period, coordinated retail investor activity, particularly on online forums, led to massive buying of out-of-the-money call options for certain heavily shorted stocks.

One of the most notable instances was with GameStop (GME). In late 2020 and early 2021, a flurry of call buying activity forced market makers to purchase the underlying stock to balance their exposures, pushing the stock price rapidly higher. This created a feedback loop where rising prices led to more call buying and further hedging-related stock purchases, escalating the upward momentum. The GameStop saga, as detailed by Nasdaq, highlighted how significant options activity could dramatically influence underlying stock prices, even leading to a gamma squeeze.⁶

Similarly, AMC Entertainment (AMC) experienced a comparable event in May 2021. Due to high call option volume and considerable short interest, market makers were compelled to buy more shares to hedge their positions, resulting in a dramatic price increase for AMC stock.⁵ This event, explained by TradingSim, demonstrated the potent effect of a gamma squeeze on highly scrutinized assets.⁴

Key Takeaways

A gamma squeeze occurs when substantial buying of options, especially short-dated call options, forces market makers to buy the underlying stock to hedge their risk.
This hedging activity creates upward pressure on the stock price, which in turn causes the options' delta to increase, requiring even more hedging purchases by market makers.
The phenomenon can lead to rapid and extreme price movements in the underlying stock, often characterized by high implied volatility.
Gamma squeezes are typically short-lived and can be highly volatile, often leading to sharp reversals once the buying pressure subsides or options expire.
While often associated with speculative retail trading, the mechanics are rooted in the obligations and risk management strategies of options market makers.

Formula and Calculation

Gamma is a second-order Greek that measures the rate of change of an option's delta with respect to a change in the underlying asset's price. In simpler terms, if delta is the speed at which an option's price changes relative to the underlying, gamma is the acceleration.

The Black-Scholes model provides a theoretical framework for calculating options Greeks, including gamma. The formula for gamma ((\Gamma)) for a European call or put option is:

$\Gamma = \frac{N'(d_1)}{S \sigma \sqrt{T}}$

Where:

(N'(d_1)) = The probability density function of the standard normal distribution evaluated at (d_1).
(S) = Current stock price of the underlying security.
(\sigma) = Volatility of the underlying asset.
(T) = Time to expiration date (in years).

Market makers are "short gamma" when they sell options, meaning their delta exposure changes more rapidly as the underlying price moves. This compels them to continuously re-hedge their positions by buying or selling the underlying asset.

Interpreting the Gamma Squeeze

A gamma squeeze is interpreted as a feedback loop in the market, primarily driven by the hedging activities of options market makers. When a large volume of out-of-the-money or at-the-money call options are purchased, market makers who sold these options become increasingly "short gamma." To remain delta-neutral—that is, to hedge their directional exposure to the underlying stock—they must buy shares of the stock as its price rises. As the stock price continues to climb and options move further in-the-money, the gamma of these options increases, meaning the market makers' delta exposure changes even more rapidly. This requires them to buy progressively more shares to maintain their hedge, fueling the upward price movement.

The interpretation is that sustained buying pressure on call options, especially those nearing their strike price, can amplify price increases beyond what fundamental analysis might suggest.

Hypothetical Example

Consider a hypothetical company, "Tech Innovations Inc." (TINV), whose stock is trading at $50. A significant number of retail investors, expecting a rally, begin buying $55 call options set to expire next week. Market makers, who typically sell these options to clients, now hold short call positions.

Initial Hedging: To hedge their exposure, market makers might initially buy a small number of TINV shares for each call option sold, based on the option's delta. If the delta is 0.30, they might buy 30 shares for every 100-share option contract.
Price Movement and Delta Increase: Suppose strong buying interest from retail investors pushes TINV's stock price to $52. As the stock price rises and moves closer to the $55 strike, the delta of the call options increases (e.g., from 0.30 to 0.45), meaning the options are more sensitive to further price changes.
Gamma's Role and Accelerated Hedging: Because the options' delta is increasing at an accelerating rate (due to positive gamma), market makers now need to buy even more TINV shares to maintain their delta-neutral hedge. For instance, if the delta moved from 0.30 to 0.45, they would need to buy an additional 15 shares per contract.
Feedback Loop: This forced buying by market makers further pushes TINV's stock price up, perhaps to $54. This, in turn, causes the delta of the $55 calls to increase even more (e.g., to 0.60), forcing market makers to buy yet more shares. This cycle continues, creating a rapid surge in TINV's stock price, independent of fundamental news. The tight bid-ask spread maintained by market makers can exacerbate this effect.

Practical Applications

Gamma squeezes are primarily observed in highly liquid markets with active options trading. They have practical implications for:

Market Dynamics Analysis: Understanding gamma squeezes helps analysts and traders comprehend unusual and rapid price movements in stocks, especially those with significant options activity. It highlights how options markets can influence equity markets, rather than just reacting to them.
Risk Management for Market Makers: For options market makers, managing gamma exposure is a critical aspect of their risk management strategies. They employ sophisticated models and continuous rebalancing to mitigate the risks associated with sudden changes in gamma, often by actively trading the underlying stock. Academic research, such as the paper "An approximate solution for options market-making in high dimension" by Fournier, Jaimungal, and Lehalle, delves into the complex hedging strategies employed by market makers to manage various "Greeks" including gamma.
³ Regulatory Scrutiny: Periods of intense gamma squeezing, like those seen with meme stocks, often attract regulatory attention. Regulators, such as the U.S. Securities and Exchange Commission (SEC), monitor market activities to ensure fair and orderly markets and to prevent manipulation. The Mercatus Center discusses how SEC regulations, like Regulation SHO, impact market maker obligations, especially concerning their hedging activities. Mar²ket makers have specific obligations to maintain liquidity and fair markets, which involves continuous quoting and hedging.

##¹ Limitations and Criticisms

While a gamma squeeze can lead to significant short-term gains for those positioned correctly, it comes with considerable limitations and criticisms:

Unsustainability: The price surges caused by a gamma squeeze are often detached from the company's fundamentals and are typically unsustainable. Once the options expire or the intense buying pressure subsides, the stock price can, and often does, reverse sharply.
High Volatility and Risk: Participating in a gamma squeeze is extremely risky due to the extreme volatility involved. Rapid price swings can lead to substantial losses for investors who enter at elevated prices or are unable to exit positions quickly.
Complexity: Understanding the nuances of options Greeks like gamma, and how market makers hedge, requires a deep understanding of options theory and market microstructure. This complexity makes it challenging for average investors to anticipate or profit consistently from gamma squeezes.
Liquidity Traps: In some cases, a squeeze can dry up liquidity, making it difficult for traders to execute orders at desired prices, further amplifying losses during rapid reversals.
Regulatory Concerns: While the activities of market makers are legitimate hedging, the rapid and often irrational exuberance surrounding gamma squeezes can sometimes raise concerns about market integrity and potential for manipulative behavior, prompting regulatory reviews.

Gamma Squeeze vs. Short Squeeze

While often occurring concurrently and sharing similar outcomes (rapid price appreciation and pain for short sellers), a gamma squeeze and a short squeeze are distinct phenomena driven by different market mechanics.

A short squeeze occurs when a stock with high short interest experiences a price increase, forcing short sellers to buy back shares to cover their positions and limit potential losses. This sudden demand to cover short positions, combined with the initial upward price movement, creates a cascade of buying that drives the stock price even higher. It is primarily a function of direct share buying by short sellers.

A gamma squeeze, conversely, is initiated by heavy buying of options, particularly call options. This forces options market makers, who are typically short these calls, to buy the underlying shares to delta-hedge their exposure. As the stock price rises, the options' delta increases (due to gamma), requiring even more share purchases by market makers, creating a feedback loop. While a gamma squeeze can amplify a short squeeze (as rising prices due to options hedging can trigger short covering), its primary mechanism involves market makers' risk management related to their options books, rather than direct short covering by speculative traders.

FAQs

What causes a gamma squeeze?

A gamma squeeze is primarily caused by a significant increase in the buying of call options, especially those that are out-of-the-money or close to their strike price. This buying pressure forces options market makers to buy shares of the underlying stock to hedge their positions, driving the stock price up in a self-reinforcing cycle.

How does gamma relate to options trading?

In options trading, gamma measures how much an option's delta (its sensitivity to changes in the underlying asset's price) will change for every $1 move in the underlying asset. A high gamma means delta changes rapidly, requiring market makers to frequently adjust their hedging positions.

Is a gamma squeeze good for investors?

A gamma squeeze can result in substantial short-term gains for investors who hold the underlying stock or call options before or during the squeeze. However, it is also highly volatile and risky, as prices can rise rapidly but also fall sharply once the squeeze ends, leading to significant losses for those who buy at peak prices.

How long does a gamma squeeze typically last?

Gamma squeezes are generally short-lived events, often lasting from a few days to a few weeks. Their duration depends on the continued buying pressure from options traders and the market makers' need to hedge. Once the buying momentum fades or the options approach their expiration date without further catalyst, the stock price often corrects sharply.