If you read WallStreetBets or any other gambling forums, you might have run into a term called “Gamma Squeeze”. But what’s the meaning of a gamma squeeze? In this post, you’ll learn:

• What the meaning of gamma squeeze is
• Why it happens
• A numerical example of how a gamma squeeze would work

In order to understand this post, you should already have an understanding of:

• What a call option is.
• What selling covered calls mean.

This is because a gamma squeeze is mostly based on call option transactions. So, if you don’t know those concepts, go ahead and click on the link above to read them first!

If you’ve already got a strong understanding of call options, read on to understand how a gamma squeeze works!

Meaning Of A Gamma Squeeze

A gamma squeeze is simply a drastic price increase due to lots of call option activity.

Why Do Gamma Squeezes Happen?

When a lot of people buy volatile calls in a short amount of time (especially close-to-expiry calls), there’s an equivalent amount of people selling these calls.

When these people sell their calls, they have to buy the underlying stock in order to hedge against potential volatility. For example:

• Gamestop was at $65 from $32 24 hours ago, and you want to sell a $95 that expires end-of-week.
• You’d be wise to cover these calls by purchasing the underlying shares (thereby covering your calls) in case you’re wrong and it jumps to $120.
• This way, your max loss is just $65 x (# shares purchased to cover your sold calls) minus your premium. Other words: your max loss is just your “net debit” – or how much it’d cost you to do a buy/write transaction.
  • A buy/write transaction is just a covered call transaction where you sell calls contingent upon your being able to purchase the underlying shares – in a single transaction. This protects you from being stuck with shares but no calls, or having calls to cover without any shares.

And this makes sense because if the stock is super-volatile, you should definitely hedge selling OTM calls to make sure they’re covered. You’re chasing high premiums due to volatility, and the buyers are chasing a once-in-a-lifetime “moon” opportunity.

But anyway, if the call-sellers must hedge their bets by buying the underlying shares, the following chain reaction happens:

• There’s an existing frenzy in buying short-dated calls, due to underlying shares skyrocketing.
  • These calls are attractive for buyers because it is relatively low risk for a very high potential reward.
  • These calls are attractive to sell because the high volatility means they demand very high premiums.
• This frenzy in short-dated calls are filled, causing sellers of the covered calls to buy massive amounts of underlying shares in order to hedge their positions.
• This massive buying of underlying shares means that the “lowest ask”-priced shares to be scooped up, causing the going rate of the shares to skyrocket.
• The price action further fuels volatility, and entices short-term investors to buy even more short-dated calls in hopes of a windfall. This starts the chain reaction again (first bullet point).

In short: the frenzy buying in short-dated call options can drive massive, “artificial” stock purchases. This makes shares skyrocket and attracts even more gamblers to buy even more short-dated call options. This frenzy continues to bubble up until people start taking profits (i.e. more people start selling than buying) and the chain reaction starts slowing down.

Example: Gamestop

We all remember $GME from January of 2021. This was a particularly remarkable event because it was fueled by both a gamma squeeze and a short squeeze.

One of the genius things of WallStreetBets (WSB) is they figured out that there was a huge short position on Gamestop. And they all collectively agreed to take advantage of this by trying to trigger a short squeeze by buying tons of shares. That is: they wanted to band together to trigger a short squeeze, which they did.

Further, another genius thing that WSB figured out is that they can compound the effects of the short squeeze by purchasing a ton of calls. Also, because WSB members are all a bunch of degenerate gamblers, they’re naturally drawn to OTM calls with high overnight payouts. Thus, they banded together to buy a bunch of calls. Here’s a snippet from a Bloomberg article:

In the options market, where dealer hedging also has the potential to fuel rallies, a record 913,000 GameStop calls traded as of 3:43 p.m. on Friday, as a showdown between short-seller Citron Research and hordes of Reddit day traders ended with the stock soaring as much as 79%. A bullish GameStop contract with a strike price of $60 expiring Friday was the most actively traded option across exchanges, according to Bloomberg data. It jumped 2,700% to roughly $1.97, from just $0.07 on Thursday.

Basically:

• A $60 strike price was $.07 on a Thursday.
• WSB folks got together and bought a lot of these short-dated call options. This is very attractive because $0.07 means it’s very, very cheap with a ton of upside.
• Heavy call purchases means heavy hedging.
• Heavy hedging = heavy purchasing = heavy share price increases (79% quoted above).
• Heavy price increases means increased volatility + stock going ITM, which made the call option increase 2700%.

GME is an extreme example and may not be typical of all gamma squeezes. Keep in mind there were huge short positions on this as well. Thus, a gamma squeeze could cause hedge funds to cover their short losses, which means buying back more shares. And short squeeze purchases can fuel the gamma squeeze, and vice versa. GME’s story is a remarkable one because it’s 2 very volatile chain reactions (gamma squeeze + short squeeze) feeding upon each other.

Meaning of “Gamma” In Gamma Squeeze

Option greeks are boring and don’t really build an intuitive understanding. The main benefit from understanding option greeks is it makes conversing with other option traders easier, so I include the classic “gamma” definition here for a more complete understanding. Feel free to skip this section if option greeks bore you because ultimately the formulaic definitions don’t really give a good understanding of the market phenomenon in my opinion.

Gamma is the derivative of another option greek: Delta. So let’s define delta:

• Delta is change of option price vs. change in underlying stock. If stock ABC goes up by $1 and the option price goes up by $0.13, you’d say the delta is 0.13.
• Deep ITM calls should have delta of 1, for example, otherwise there’s an obvious arbitrage opportunity here. For example: a $3 strike on a $20/share stock would have a delta of 1. This way, if the $20/share goes to $21/share, then the $3 strike should now move from $17 to $18.

Gamma is the change of delta over time. Intuitively: the “higher” the gamma is, the more volatile the stock is with respect to the option.

• Example: at-the-money (ATM) calls have a higher gamma than something that’s deep OTM or deep ITM. This is because ATM calls are always very close to oscillating in and out of intrinsic value (i.e. completely worthless vs. not).
• But if an OTM option has a very high gamma, it means that the actual shares are moving so fast and is so volatile that the delta is changing very quickly (i.e. deep OTM converging to shallow OTM or ATM fast, or the opposite direction).

Since gamma is a second-derivative, you can make the physics analogy where gamma is to price as acceleration is to distance. If the distance (price) is relatively stationary and then all of a sudden is moving at an extremely high velocity (delta), then you can make the implication that the acceleration (gamma) is high as well.

Another way to think of gamma is for apples-to-apples comparison of options of the same delta. Would you rather:

• Buy an OTM call with a 0.8 delta with a tiny gamma, or
• Buy an OTM call with a 0.8 delta with a huge gamma?

The answer’s the latter. A 1 delta would mean we’re deep ITM which means we need the delta to be more volatile. A 0.8 with a huge gamma has a better chance of going ITM than a 0.8 delta whose gamma is low (since the delta, and thus the implied underlying at-the-moniness isn’t going to change that much).

Thus, in a gamma squeeze where the gamma is very high, it can be very lucrative to purchase even $.07 options because even if it has a very low delta right now, delta can change very rapidly in the next 10-15 minutes. And if that happens, then the $.07 option becomes very expensive, very fast.

In Sum

Below is a summary of the meaning of gamma squeeze.

Gamma squeezes are extreme price movements that’s caused by heavy purchasing of call options (usually shorter-dated options). Heavy call option buying means the counterparties must hedge by purchasing a very heavy volume of underlying shares. This in turns causes a price increase, which causes more option buying, and the chain reaction continues.

Keep in mind options can be remarkably risky. While gamma squeezes imply high gamma, high gamma does not imply a gamma squeeze is happening (for example, regular ATM options).

What makes gamma “squeeze” a squeeze is the positive feedback loop of speculation. The squeeze stops when the market mania stops and people stop purchasing call options en masse and/or when market participants start cashing out en masse (thereby creating downward price pressure).

Thus, while gamma squeezes can be extremely lucrative, keep in mind the following:

• They are fairly rare in occurrence, so identifying one is difficult even if it seems easy in retrospect.
• Since you can’t predict the future, timing the market is impossible. “Going in” on a stock in a gamma squeeze can end poorly for you if the squeeze stops as you jump in. You can actually lose a lot of money this way because a highly squeezed stock has the farthest to fall.

As always, do your own research and don’t gamble what you can’t risk. And yes, in my opinion, this strategy is generally gamble and not an investment strategy.