What is gamma squeeze?

A gamma squeeze occurs when investors are forced to buy a stock because of a change in its price. This leads to the stock surging. 

Market makers who sell options potentially have to deliver the underlying stock. To limit risk, they often buy or sell shares in this stock. If buying costs more than they planned for, traders face a loss, which can be large.  

For example, a call option gives investors and traders the opportunity to buy a stock at a certain price within a specific time frame. When there’s excessive buying activity for these call options, a gamma squeeze can take place, which feeds higher prices, creating an upward spiral.

A gamma squeeze is different from a short squeeze. In a short squeeze, investors are forced to buy back the shorted stock due to the share price rapidly increasing. 

Gamma squeezes offer unique opportunities for investments and traders, but there’s a significant amount of risk involved. Timing is incredibly important, as the stock price can reverse sharply following a gamma squeeze.

Gamma squeeze explained

When experts and analysts talk about a stock squeeze, they are referring to a situation where investors are forced to change their stock positions that they otherwise didn’t want to. For example, if an investor is short on a stock, they may decide to cut their losses during a price rally when it’s clear that the stock has more substantial buying power than they expected.

A gamma squeeze takes that concept to a different level. Usually, investors are creating an options contract with a market maker, rather than an individual investor. These market makers are “short gamma” by selling these options. They are called market makers because they “make the market” or provide liquidity. The term “gamma” refers to the maths involved in options pricing.

When traders buy call options, it creates risk for the market makers. To hedge that risk, they buy and sell the underlying stock. When a stock rises, market makers may be required to buy the underlying stock, which fuels the rally, creating a gamma squeeze.

Gamma squeeze example

There have been several high-profile examples of massive gamma squeezes, particularly in the case of AMC (AMC) and Gamestop (GME). In both cases, gamma squeezes led to a massive rise in both companies’ relative stock price.

With GME, many analysts agree that the stock price surged in January due to a short squeeze. Some institutional investors were betting that Gamestop’s business model was outdated, and shorted the stock, hoping to profit if the value of the asset fell. When retail investors began buying the stock in droves, short sellers were forced to abandon their short positions and buy back the stock, leading to a massive price rally. 

That rally was also fuelled by a gamma squeeze. Hedge funds that bet against Gamestop were forced to close their short positions due to the rapidly rising stock price. GME has risen over 4,800% on the year, and the gamma squeeze has been instrumental in that surge.

AMC rose by more than 1,200 within a year after a gamma squeeze. This is because investors were purchasing AMC stock and purchasing trading options that eventually forced market makers to hedge their positions by buying the underlying stock.