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What is a Gamma Squeeze? How does it affect stock price?

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What is gamma squeeze?

The word “squeeze” can refer to a sudden price change in stocks. This may make investors feel as if their positions in the stock are threatened as a result, they change those positions. Gamma squeezes can happen when widespread buying activity of short-dated call options for a particular stock takes place. This upward spiral results in more call buying, causing the price to go higher and higher. As options trading is active in mutual funds, ETFs, or SPACs, the knowledge about gamma squeeze is very crucial.

Gamma Squeeze Explained:

A gamma squeeze is a type of trade that occurs when there are large volumes of stocks being bought or sold from the market. When traders buy or sell out their positions, it leads to a surge in share prices- this phenomenon is known as a Gamma Squeeze.  

To understand Gamma squeeze we need to understand “call” options trading. A call option is basically a right given to the investors to purchase 100 shares of stock at a fixed strike price, within a given time period. Now, these 100 shares are normally sold by market makers (stock exchange workers, banks, or private firms) whenever there is any call option trading. Suppose that, a large number of people bought call options from market makers, which results in a large short position for market makers in their stocks. At this moment, if the price of shares rises, the market makers will face huge losses. Now, to normalize this loss, they will start buying stocks at market price to recover from their short options position, which in turn increases the demand and raises the stock price furthermore. 

What is Delta? 

Gamma is considered as the change in delta per stock. So what is this delta? Delta is defined as the amount of option price movement relative to the movement of underlying stock price. The delta value will be always between 0 and 1. If the stock price is trading below the strike price of the call option, the value of delta will be closer to 0 and if the stock price is trading above the strike price of the call option, the value of delta will be closer to 1.

Suppose that the delta of any stock is 0.2. What this means is that for every 1 US dollar rise in the stock price, the price of call options will rise by 0.2. This means the price of the option will fluctuate by the delta value with the fluctuation of the stock price.

What you need to understand is that this Delta value changes as the stock price increases or decreases. It is not constant, and this change of delta formed the gamma. 

Duration of Gamma Squeeze:

Whether it is a gamma squeeze or a short squeeze, the duration is unpredictable. As the investors feel that they are squeezed which makes them buy or sell their shares even if they don’t want to, makes the duration incalculable. A gamma squeeze may last as long as weeks or as short as a day, based on the market cap, share outstanding, warrant outstanding, involvement of day traders, etc. The gamma squeeze might stop once the market makers are fully hedged. That is if the market makers have fully recovered from the loss they have got by selling option call shares. They can now stop buying the stocks at market price which will eventually decrease the demands, bringing the gamma squeeze to an end. This is called reverse gamma squeeze.

Risk of Gamma Squeeze:

With the reward of getting profit by a huge margin to retail investors, it brings risk to option traders. The risk of gamma grows as the option call expiration period comes closer. At this point, the gamma value will be very high causing drastic change in not only the stock price but also the option price. It is not a problem if the stock price is still increasing, but if the stock price reaches its peak then the price will reverse. When the reverse gamma squeeze hits, that is where it gets messy. The $1 drop in stock price will cause a huge drop in option price resulting in a huge loss if I want to hold that option. 

This can be explained by the following diagram:

Delta change

The green and red curves in the above diagram show the option price change (i.e. Delta) with the change in stock price. As the DTE (Date Till Expiration) for the green curve is 45 days, the stock price drop from 75 to 74 will not cause a huge drop in the option price. But for the red curve which has a DTE of 2 days, the option price drop is significantly high. As an options trader, if you want to hold your options then this is a huge risk that you cannot afford.

Gamma Squeeze vs Short Squeeze:

As both the gamma squeeze and short squeeze cause the sudden increase in the share price, the working of these two is quite different. While gamma squeeze is caused due to the “call” options trading by market makers and to hedge their loss they are forced to buy stocks at a market price resulting in more demand for stocks causing a sudden increase in share price. But the short squeeze happens due to the involvement of short-sellers.

Short sellers are those who borrow the shares from brokers hoping that the share price will go down. As they borrow the shares, they also have to return it back as they are just imaginary shares. Once the short seller borrows the shares, he will sell those shares at market price, and afterward if the market price decreases, he will buy those shares again and give it back to the broker. 

Suppose that there are a lot of short-sellers that have borrowed the shares from the broker and have sold them at market price. Now, if the market price increases these short sellers are forced to buy the stock to hedge their loss. This increase in demand attracts normal investors to buy the stocks, causing the sudden rise in stock price called a short squeeze.

Final words:

Gamma Squeeze is very risky if you are new to investing and don’t know this term. But if you are familiar with it, then it can open a good opportunity for investors to earn more revenue in a short interval of time. As the price is rapidly changing, you need to be careful as the price drop can occur at any time. If you are not aware, you will lose all your gains. Also, you need to have an understanding of smart money and how to analyze it. That is why; we need an analytic tool like SPACrun that can help us make strategic decisions in such scenarios. Signup to SPACrun now to get 7 day free trial.

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