Understanding the Gamma Squeeze

Interactions between different financial markets occasionally create strange price movements. Take the gamma squeeze, a sharp increase in a stock's price that happens when three forces align: increased call-buying activity, a rapid rise in the price of the underlying stock or asset, and hedging on the part of option market makers, who buy more shares to hedge their risk against call options they initially sold.

This dynamic often kicks off when the first factor comes into play—retail traders start buying call options in anticipation of a price increase in the underlying stock or asset. If the price of the stock rises significantly over a short period of time, market makers who have sold call options need to hedge themselves against the risk of the options going in the money, so they buy shares of the stock, which in turn can push the stock price even higher. If the stock has a low float, meaning a small number of available shares for trading in the open market, the velocity of a rally in the stock can be more extreme.

The higher the stock price climbs, the more shares they need to buy to maintain their hedge, regardless of whether the company's long-term fundamentals justify the short-term increase in price.

The self-perpetuating cycle of a gamma squeeze is a lot like a short squeeze, in which short-sellers buy shares to close their position, forcing a stock to rise and causing more short sellers to buy shares to cover their positions. The price increase sparked by a short squeeze has everything to do with temporary market conditions and nothing to do with the underlying company's long-term prospects.

To understand the gamma squeeze, it helps to understand gamma as well as other dynamics in the options market like the role of market makers, hedges, and the put/call ratio.

In the options greeks world, delta represents the expected rate of change of the price of an option relative to changes in the price of the underlying stock or asset. It tells a trader how much the price of an option is expected to change, either higher or lower, because of a change in the price of the underlying stock or asset. Positive delta means the price of the option is expected to increase as the underlying asset's price increases. For example, if an option has a delta of 0.5, then it is expected to rise 50 cents in value for every dollar increase in the underlying stock's price. Negative delta means the price of the option will decrease as the underlying asset's price increases. Long call options have positive delta, and long put options have negative delta. Also, keep in mind that delta is a dynamic figure, fluctuating in value as the underlying price changes, implied volatility changes, or time passes.

Gamma measures the rate of change of delta. It tells how much an options contract's delta will change if the price of the underlying asset changes. Gamma is generally highest when an option is at the money and approaching expiration. At-the-money options have the most time value embedded in their price and become more sensitive to underlying price changes as the expiration date approaches. Gamma generally decreases the further in the money or out of the money the option strike is relative to the underlying price.

Market makers are required to take the other side of options positions. If a trader wants to buy a call option and no other retail trader wants to sell the option, a market maker steps in. The market makers then manage their options positions to minimize their risk.

Often, the market maker's total options position comes close to having a balanced mix of long and short put and call positions. If it's unbalanced, though, the market maker will likely want to hedge risk by taking or offsetting positions in the stock or options to keep the delta of the net position at or near zero.

A delta-neutral hedge may protect a position against a small move in the price of an underlying asset. A large price change will change the delta, though, and that brings gamma into play. If market prices are volatile, a market maker may turn to a gamma-neutral hedge. The objective of such a hedge is to get the gamma of the combined position on an underlying down toward zero to help offset potential changes in delta due to significant changes in the underlying's price.

To hedge the gamma of a short call position, a market maker will typically buy shares of the underlying stock. This hedges the market maker's portfolio, ensuring they have enough shares on hand to settle any exercised options.

Traders can look up the delta and gamma of an option along with stock and options prices on the thinkorswim^® platform or Schwab.com. These numbers are useful, but the numbers alone don't signal an upcoming gamma squeeze.

Another number to consider is the put/call ratio for the underlying asset based on the open interest. This is the number of outstanding put options divided by the number of outstanding call options. It's often used as a sentiment indicator, meaning that if there are more puts than calls on a stock, sentiment is generally considered bearish. The opposite is true if there are more calls than puts.

If the ratio of puts and calls is extremely unbalanced, traders can expect two things. First, market makers and others will likely become especially aggressive about managing risk. Second, an imbalance signals that there could be unusual market activity. For example, if the stock has low trading volume or few shares outstanding, and the stock price makes an aggressive, sudden move higher, this could create an environment for a gamma squeeze and a potential opportunity for anyone long the stock—and a potential disaster for anyone who is short.

Gamma squeezes, like short squeezes, are not common. They tend to occur when there is heavy, speculative buying of stock shares and call options in a thinly traded stock that forces market makers to take decisive action. Nevertheless, gamma—like delta, ratios, and other indicators—can be useful in many other trading scenarios.