Gamma Squeeze: How open options can prompt meteoric stock price rises
A gamma squeeze may be a rather mysterious concept for many investors, but it can dramatically affect a company’s stock price over very short periods of time. It’s best described as an investment term for a very rapid rise in the share price triggered by the market’s reaction to large trading volumes in one direction.
But does this make it a positive for an investor, or can threaten the stability of their overall portfolio?
Here we take a closer look at the gamma squeeze meaning, what triggers one, the impact it can have on your holdings, and how long it generally lasts.
Why are people talking about a gamma squeeze?
While a gamma squeeze is a common term among professional investors and traders, it’s recently become more mainstream. This is largely due to the more widespread sharing of information online, according to Danni Hewson, financial analyst at AJ Bell.
Hewson likened it to the situation when the emergence of crypto currency millionaires sparked “a buying frenzy” among a new generation of investors.
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What is a gamma squeeze?
So, what is a gamma squeeze in stocks?
A gamma squeeze is when shares rise very sharply as market makers have to close out their positions on the back of large trading volumes. It happens when investors are forced to buy a stock because of a significant change in its price. As a result of this increased demand, the stock price rises sharply.
Market makers who sell options may have to deliver this underlying stock. In order to limit their exposure to risk, they often buy or sell shares in this company.
A call option providers investors and traders with the opportunity to buy a stock at an agreed price within a specific time frame. This gives them a degree of certainty as they will know what the costs will be should they find themselves in such a scenario further down the line. However, when there’s rather excessive demand for these call options, a so-called gamma squeeze can take place.
So, how does a gamma squeeze differ from a short squeeze? While the concepts are similar, short squeezes happen to traders and not market makers. When stock markets move rapidly in response to significant trades in a particular direction, traders can be forced out of their positions.
This can lead to them having to either sell stock or add additional funds to their trading accounts. Again, these changes in demand and selling patterns can cause stocks to rocket in value.
Gamma Squeeze explained: Why does it happen?
According to AJ Bell analyst Danni Hewson, a gamma squeeze is “a complicated scenario” that most retail investors would do well to avoid.
“If traders are short of stock because someone has been buying call options, it could create a scenario ripe for a gamma squeeze,” she said. “The price goes up and the higher the stock goes more traders have to close out their positions which creates more buying and so on.”
Of course, there is a clear problem with this scenario. It’s one that investors need to acknowledge, as it can adversely affect a company’s valuation.
Gamma squeeze indicator: What causes high trading volumes?
Trading will be affected by views and opinions. These can be based on everything from particular world events to rumours spreading online.
In recent years, internet message boards have become an influential mover of certain stocks, particularly new companies that aren’t followed closely by analysts. Reddit, the innovative website that enables people to establish their own specialist communities online, has become a particularly popular destination.
Posts have generated excitement about relatively unknown businesses that are being tipped for great things. However, it’s vital that you carry out your own research into such claims.
Reddit’s’s WallStreetBets forum has 12.5 million members and has been credited with influencing the stock prices of companies such as GameStop (GME) and AMC (AMC).
Gamma squeeze options: What is an option and how does it affect price gains?
A call option is best described as a contract that gives the buyer the right to purchase an agreed quantity of an underlying asset at a set price for a certain period of time. A put option gives the holder the right to sell a defined quantity of an underlying asset at a specified price within a fixed period of time.
As we have noted, gamma squeezes are often associated with the trading of options. For investors unsure how they can work, there are plenty of potential dangers. They can cause sharp spikes, followed by equally rapid falls.
Whether or not you can benefit from a gamma squeeze depends on timing. If you get it right, you could be in the money. Get it wrong and you could suffer losses. Trading in a gamma squeeze is unpredictable and very difficult to get right. Anyone operating in this area must be prepared to endure high levels of risk.
How this can prompt meteoric stock price rises
A gamma squeeze example came in June 2021 when shares in AMC Entertainment Holdings soared to a record high. The stock price stood at $12.08 on 21 May, 2021, but by 2 June it had rocketed to $62.55. This represented an incredible increase of 418%.
This impressive rally was partly attributed to heavy trading of equity options that give buyers the right to buy or sell shares at a fixed price in the future. The AMC gamma squeeze is an illustration of how prices can rise in response. For investors buying and selling at the right times, there are handsome profits to be made.
Another example came with GameStop, the video game retailer. Its stock soared 400% from $16.25 on 18 January 2021 to $81.25 just seven days later on 25 January. According to analysts and industry observers, a gamma squeeze from call options trading was the most likely explanation for the rapid rise.
FAQs
What triggers a gamma squeeze?
When investors are forced to buy a stock because of a change in its price it can result in the stock price surging. Traders buying call options can create risk for market makers. When a stock rises, market makers may be required to buy the underlying stock, which fuels a rally.
How does a stock go up with a gamma squeeze?
Traders having to buy the underlying stock results in increased demand. When demand rises for an asset, its price will subsequently rise.
What happens after a gamma squeeze?
This is not set in stone. The concern is that once a gamma squeeze reaches its peak, fortunes can quickly turn. This may mean the stock price falls just as rapidly as it soared. This can leave investors nursing losses.
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