When stock prices experience rapid shifts, the conditions may be ripe for a squeeze. In this scenario, investors may find themselves buying or selling shares of stock outside their normal trading pattern in order to minimize losses. A gamma squeeze is an extreme example of this, in which investor buying activity forces a stockâ€™s price up. Gamma squeezes are often associated with options trading and they can be problematic for investors who donâ€™t fully understand how they work. A financial advisor can provide valuable advice about gamma squeezes and options trading.
Gamma Squeeze, Explained
As mentioned, a squeeze can happen when stock prices unexpectedly come under pressure. Investors who own the stock may feel â€œsqueezedâ€ by rapidly changing prices and as a result, they change their positions in the stock.
A short squeeze is a specific type of stock squeeze. With a short squeeze, an increase in stock prices can force people who shorted the stock to buy back their shares. Shorting means investors are betting that the price of a stock will go down, rather than increase. A short squeeze can end up driving stock prices up, sometimes significantly, though this upward shift in pricing may not be sustainable for the long-term.
A gamma squeeze can happen when thereâ€™s widespread buying activity of short-dated call options for a particular stock. This can effectively create an upward spiral in which call buying triggers higher stock prices, which results in more call buying and even higher stock prices.
Gamma is an investment term associated with the â€œGreeks.â€ The Greeks are a set of terms that are used to describe various positions when trading options. Delta, for example, explains how the rate of changes of an options price corresponds to the change in the underlying stockâ€™s price. Gamma is related to the delta, as it measures how the latter changes as a stockâ€™s price shifts up or down.
If thatâ€™s all Greek to you, hereâ€™s a simple explanation. Gamma and delta, along with the other Greeks, can be used together to determine what may happen with a stockâ€™s price over time. This can then be used to determine what position to take when trading options for a specific stock.
How a Gamma Squeeze Works
Certain conditions have to be met for a gamma squeeze to manifest in the market. It starts with investors making assumptions about a particular stockâ€™s price. Specifically, they assume that the stock will rise in price.
This leads to buying short-dated call options in the stock on a large scale. A call optionâ€™s value increases when the underlying stock itâ€™s associated with increases in value. Meanwhile, this puts the institutional investors selling the options in a short position.
If this pattern continues with investors sinking more money into call potions, that can force institutional investors to buy more shares of the stock. This is a necessary step for hedging against the short position they now find themselves in.
The gamma squeeze happens when the underlying stockâ€™s price begins to go up very quickly within a short period of time. As more money flows into call options from investors, that forces more buying activity which can lead to higher stock prices. Investors who purchased call options and sell when stock prices are high can reap sizable profits but the institutional investors who had to cover their short positions might see significant losses.
What Causes a Gamma Squeeze?
Gamma squeezes can occur as the result of widespread speculation about where a stockâ€™s price may be headed. For example, if a company is struggling financially then institutional investors may decide to short the stock in the belief that the price will fall. That isnâ€™t out of the ordinary but what is unusual is when a group of investors or a single large institutional investor starts buying up stock, resulting in a short squeeze. For example, January 2021 saw an increase in short squeeze activity surrounding several companies, including GameStop Corp. (GME) and AMC Entertainment Holdings (AMC).
Over a relatively short period of time, GME experienced a sharp spike as retail investors coordinated to drive up the stockâ€™s price. At one point, the stockâ€™s price had increased by more than 400%. At the same time, a number of large hedge funds held short positions in the company, owing to negative assumptions about its long-term financial outlook.
As attention surrounding GME grew, the stockâ€™s price continued to climb, attracting more investors. This put market makers in the position of having to buy additional shares, which meant more price increases. As the stockâ€™s price continued its unprecedented rise, hedge funds that were short in the stock finally were forced to close out their positions, in some cases booking billions in losses.
What Gamma Squeezes Mean for Investors
A gamma squeeze could be an opportunity for investors but it can also be risky. Depending on whatâ€™s driving a short squeeze and the resulting gamma squeeze, they can last for days or weeks or peter out very quickly. For that reason, timing plays an important part in determining whether a gamma squeeze results in a profit or a loss for your investment portfolio.
Once a gamma squeeze reaches its peak, price reversals can happen very quickly and you may see a steep decline in stock prices. For this reason, trading options is something that may not be right for every investor unless you have a high tolerance for risk.
Options trading in general is riskier than trading stocks, mutual funds or ETFs simply because thereâ€™s a certain amount of guessing that goes on about what will happen with a stockâ€™s price. Guess right and you could benefit from a sizable payoff. Guess wrong, on the other hand, and you may face steep losses.
The Bottom Line
Gamma squeezes can create opportunities for investors when they happen but itâ€™s important to keep the risks in mind. The GameStop gamma squeeze provides a great example of how much timing matters when attempting to take advantage of this kind of strategy. If youâ€™re interested in options trading, then it helps to choose an online brokerage account thatâ€™s fee-friendly. Many online brokerages now offer $0 commission-fee options trading, with low per contract fees.
Tips for Investing
Consider talking to a financial advisor about the pros and cons of options and how to spot a gamma squeeze in the making. If you donâ€™t have a financial advisor yet, finding one doesnâ€™t have to be complicated. SmartAssetâ€™s financial advisor matching tool can make it easy to connect with professional advisors in your local area. If youâ€™re ready, get started now.
Whether youâ€™re considering getting started with investing or youâ€™re already a seasoned investor, an investment calculator can help you figure out how to meet your goals. It can show you how your initial investment, frequency of contributions and risk tolerance can all affect how your money grows.
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