Investing > Gamma Squeeze Explained

Gamma Squeeze Explained

A big gamma squeeze can leave you set for life (or at least a good portion of it). But, it also has the power to reduce your income to double digits. Tread carefully.

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Updated January 09, 2023

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Can you imagine what it would feel like to make $30,000 in one month?

That is exactly what you would have made if you’d invested $1,000 in GME in late 2020, when its gamma squeeze began, and sold your investment at the peak of the craze. However, that same squeeze turned out to be a double-edged sword as some funds lost more than $6 billion under those same circumstances after making the wrong decisions. 💰

The thought of such a drastic loss, would make even the most experienced traders retreat and opt for a more passive, long-term approach. But, some would argue that passive investing is no way to thrive in a bear market—which just might be approaching as the economy continues to search for stability amidst the rising inflation, and the societal recovery from COVID-19.

On the other hand, just as big losses are daunting, the thought of earning limitless returns can be alluring—but daydreaming about riches won’t get anyone anywhere. Nor will blindly investing in high-risk trades, and if gamma squeezes are anything, they are risky double-edged swords.

So, let’s learn what a gamma squeeze is, how it works, and how you can make sure its blade stays on your side.

What you’ll learn
  • What is a Gamma Squeeze?
  • How a Gamma Squeeze Works
  • Gamma Squeeze vs. Short Squeeze
  • How to Trade a Gamma Squeeze
  • Potential Risks of a Gamma Squeeze
  • Example of a Gamma Squeeze
  • Conclusion
  • Get Started with a Stock Broker

What Exactly is a Gamma Squeeze? 👨‍🏫

A gamma squeeze represents a rapid rise in the price of a security that is closely tied to the options market. This phenomenon—and its cousin, the short squeeze—grabbed massive public interest amidst the great GME craze of 2020/2021.

In early 2022, AMC—another company affected by the meme stock craze—was again shorted to levels not seen since 2021, creating circumstances for another possible big gamma squeeze.

While reading about events can be daunting at first as it often features many of the so-called Greeks—most notably gamma and delta—it is actually quite simple to understand. In a nutshell, a gamma squeeze is a matter of supply and demand, and the problems with meeting big, sudden demand.

How Does a Gamma Squeeze Work? 👷‍♂️

A gamma squeeze is primarily an interaction between two groups—market makers and options traders. Market makers are big players that provide liquidity by buying and selling large quantities of assets and derivatives. Think Goldman Sachs and Deutsche Bank—who both made a killing during the 2022 SPAC craze.

A representation of how market makers operate during a trade, profiting from bid/ask spreads.
Market makers profit from bid/ask spreads and maintain liquidity in the market.

Most gamma squeezes start when many small—or a few really big—options traders spot a very promising out-of-the-money option on the market. Think of a company, let’s call it RoketZ, that has stocks valued at $15. A market maker might put out options to buy RoketZ stocks at $30 at a future date. There are numerous contracts like this on the market, but for some reason, this one is a real attention-grabber.

Whenever options are bought, market makers have to buy corresponding stocks to cover their position—if an investor decides to exercise their options, market makers must own the underlying assets to be able to sell these stocks. 

Investors purchase options for a plethora of reasons. For some it could be the result of a hunch. Other investors may act after meticulous analysis. And there are also the investors who make a decision after witnessing high trading activity through the research and analytical tools provided by the most popular options brokers. The reasons are endless.

The Price Loop ♻

However, sometimes prices just go wild—the GME craze being a prime example— and this can be really bad for market makers. Essentially, as more people buy options, market makers have to buy more shares to cover themselves.

In this way, market makers are forced to act against their best interest—they prefer if the stock prices remain static. The increased volume of buying in which they are partaking adds to the price hike the asset is experiencing which in turn makes buying out-of-money options for that security more enticing—it is already on an upward trajectory and likely to result in profits.

This means that what was initially a good trade for the market maker becomes worse and worse and once the prices go over those targeted $30, the market makers start really losing money as they are paying $35, $40, $50, or even more for the shares they can sell for $30. 

The rise in the price of the underlying asset means that new options with higher targets will be issued. This is both a natural part of the market and can be a Hail Mary for the market makers to recoup their losses. Essentially, if the share prices go to $35 from the original $10 they will lose on those trades, but if they issue new options for $45 and the prices stabilize at $40 they can still recoup their losses.

In a gamma squeeze, a loop is created which can go far beyond the initial $10 and make any new options contracts ultimately lose the market makers even more money.

This loop can continue for some time, and there is really no limit as to how high the prices can go before they start correcting—which makes both the gains and losses for everybody involved theoretically infinite.

What is the Cause of a Gamma Squeeze? 🤔

While the basic principle behind a gamma squeeze is relatively straightforward, its causes aren’t quite so simple. While there are rules that determine stock prices, the behavior of traders and investors always has a major impact—and human actions are driven by numerous factors, many of which are unpredictable and irrational.

Generally speaking, gamma squeezes start with widespread speculation on the future of a company. This speculation often comes from the belief that certain stocks are undervalued—meaning that they are likely to rise and that buying options will likely be profitable.

However—as was dramatically showcased with the case of GME and AMC—a gamma squeeze can also largely be caused by spite. In the case of that particular craze, a perfect storm was caused by GameStop enthusiasts who, on the one hand, saw a company they loved in trouble, and on the other saw an opportunity to harm institutional short sellers bigtime.

How Long Does a Gamma Squeeze Last? ⌚

As a rule of thumb, gamma squeezes don’t last very long and tend to be over within hours. Essentially, a gamma squeeze can only be sustained as long as there are prospecting traders—and it peters out when their appetite for risk is sated.

On the other hand, the infamous GME squeeze lasted for well over a month, and, arguably, continued in a diminished form for the better part of 2021. It was, however, a perfect storm and is a major exception to the rule.

Still, since many experts and pundits believe that meme stocks are here to stay, it is a window to an occurrence that just might become increasingly common.

The duration of the GME gamma squeeze had several elements most other such crises simply don’t. Its target was a troubled company that many felt nostalgic about.

It was heavily shorted by various hedge funds—which are relatively disliked for numerous reasons, both founded and unfounded.

GME also had a vocal and zealous crowd of supporters which both helped spread the word, generate hype, and provided a kind of a guarantee the squeeze would last for anyone invested.

Gamma Squeeze vs. Short Squeeze ⚔

The GME gamma squeeze is often also called a short squeeze for a very simple reason—it is both. A short squeeze often happens at the same time as a gamma squeeze and functions in a very similar way.

Perhaps the main difference is who the major losers of such events are—provided the squeeze was big enough to generate substantial losses. As we’ve established, market makers—usually big institutional investors—tend to lose the most from a gamma squeeze through issuing out-of-the-money contracts that dramatically go in-the-money. 💵

As its name implies, the losers of a short squeeze are short-sellers that are forced to close their position under unfavorable circumstances. While many short sellers are institutional investors like the aforementioned hedge funds, with the advent of several leading brokers that are specifically designed for short selling, the floodgates have been truly opened for the general public. As a result, many individual investors are also trying their hand at short selling and can lose a lot of money in a short squeeze.

Since both short selling and options trading are potentially lucrative practices that are heavily dependent on speculation, there is little wonder that these two types of a squeeze often go hand-in-hand. 

Luckily for individual investors, since squeezes tend to last only a short while, they can often simply wait for the craze to blow over—and since they are unlikely to have ventured billions on individual trades, even the incurred losses should be limited. ✋

Unfortunately, if we really do see repeats of the GME scenario, squeezes might become more dangerous for all investors. Such a future is somewhat likely as both perceived and real problems with short selling are still pervasive, and the mostly hated practice of naked short selling is still believed to be widely utilized by numerous large investors.

While naked short selling is hard to decisively prove, the fact that the SEC declared it can be used to depress stock prices as early as 2006—which would be to the benefit of the issuers of out-of-the-money options contracts—makes fertile ground for more rage and conspiracies.

How to Trade a Gamma Squeeze 🏗

Trading a gamma squeeze is usually a very risky business. Since it is—by definition—a period of a rapid price surge often followed by a quick drop, the time to make a profit is relatively short, and things can go wrong fast.

That being said, trading a squeeze can likewise be insanely profitable.

Squeezing Options 📃

The first thing to understand when trying to trade a gamma squeeze is that it begins in the options market—and generally, if you are in on it, you’ll be trading options contracts. A relatively common strategy is purchasing a contract that is close both to its target and to its expiry date.

For example, if John buys a contract market for $30 that expires in two days at the price of $28 for assets that are on the rise, he’s most unlikely to lose money and can be in for a treat—since assets affected by a squeeze tend to shoot up, that contract might just be worth $100 or more by the time he sells or exercises it.

Squeezing the Shares 📜

On the other hand, since the price of the actual stock is going up as well, John can get in on the action by simply buying the affected shares. However, one should remember that trading stocks under these circumstances isn’t really safer than dealing with options.

Either way, making a profit during a squeeze doesn’t always entail dabbling in day trading. Under the right circumstances, investors can generate decent gains by entering a semi-long position at the right time.

For example, people who bought AMC shares at the very start of the craze at the end of 2020 and sold them a year later in January 2022 still made a decent profit—AMC went from just over $2 to just over $27. While it is true they could have made an even greater profit if they sold earlier, the semi-long option is less sensitive and has the benefit of triggering less punishing capital gains taxes.

Shorting the Squeeze 📈

Considering that a gamma squeeze pretty much guarantees that the price of the underlying asset will be significantly overpriced, attempting to short sell it might appear as a natural choice. Such an action can be hugely profitable, but is also very risky and often simply not feasible.

A real shorting opportunity is only likely to happen within longer gamma squeezes—and most of these price hikes go from start to finish within just a few hours. Furthermore, as is really apparent in hindsight, a long squeeze can be wildly unpredictable and highly dangerous.

Many large traders that held short positions with GME at the start of the craze were very vocally convinced they’ll still end up on top pretty much until the very end—which was rather sensible at the time since most traditional considerations of technical analysis were pointing to GameStop being a big loser.

Compounding these issues with the unpredictability of the squeeze itself, there are no guarantees on how far the prices will fall after the turmoil is over. GME stocks were on a pretty stable downward trajectory for years. They were valued at $24 in the Spring of 2017 and fell to just under $3 three years later—but spent Q1 of 2022 firmly above $90 despite the craze being over.

This means that even trying to short GME while at a high price in February of 2021—or even during the summer of that year—could still cost an investor a lot of money.

How to Identify a Potential Breakout 🕵️‍♂️

Ultimately, the best way to really profit from a gamma squeeze is by getting in on the action before the turmoil even starts. In practice, this would entail correctly predicting a true breakout.

Correctly trading a gamma squeeze can really become a get-rich-quick scheme, but we shouldn’t forget that finding a winning opportunity and laying the groundwork is hard work. Generally, we’d likely want to consult the many technical indicators used in options trading.

Luckily, doing our due diligence and properly researching options and stocks is made much easier with the help of the top stock analysis software.

However, since many of the more mathematical indicators and methods are designed to work with a wholly efficient market—they can’t really account for management changes, PR and other blunders, and political turmoil—a more holistic approach of the mosaic theory can be another useful tool when looking for winning contracts.

Be Aware of a False Breakout ⚠

Trying to figure out what the future holds is a perilous endeavor for anyone lacking an actual crystal ball. It is no surprise that false breakouts often happen. In essence, these represent both breakouts that happen but never turn into a gamma squeeze—they remain far too limited to help you profit from your contract—and breakouts that never actually materialize.

There is no way to guarantee that we will never misidentify a potential breakout as we can never be 100% certain of what will happen in the stock market. The real defense in such a scenario is either not to bet too audaciously—not to venture too much money on a contract—or not to bet on a squeeze at all.

Potential Dangers and Risks of a Gamma Squeeze 🚧

Making money off of gamma squeezes is difficult because the opportunities they present are unpredictable and time-sensitive. The former of these is rather obvious as it takes a lot of skill to reasonably reliably foresee when a squeeze will start, and when it will pivot into price corrections.

This makes both achieving profits and maximizing our gains hard. Losing money on an expired out-of-the-money contract is bad, but making $50 instead of $100 if we close our position at the wrong time can also sting.

If an investor is trying to generate returns on a squeeze using options, they have two time constraints. On the one hand, the asset they chose has to get them in the money before the contract expires—and on the other, they also have to deal with the usual quick pace of a squeeze.

Time-sensitive and generally short-term trades are far riskier than long positions, and the difficulties of staying alert and keeping a cool head become very obvious when one considers just how many day traders end up losing money. ☀

Additionally, investors might correctly predict a breakout and plan their trades near perfectly and still lose. If they haven’t automated certain aspects of their trades through—for example—with a certain type of stock order, it is possible to simply not be present to execute the trade at the right moment

On the other hand, even if an investor placed automated fail-safes, they might execute at a profitable but suboptimal moment.

Considering the fast-paced nature of many of the actions concerning gamma squeezes, and the adrenaline from making successful trades, you might start suffering from a victory rush—making you more impulsive and willing to take bigger, unwise risks.

Finally, it is often far quicker to lose a lot of money than to earn it back—as is publicly visible with large hedge funds and other institutional investors—and major losses can do a lot to stifle your long-term returns.

How to Mitigate the Risks of Trading a Gamma Squeeze 🧐

As is often the case with the stock market, the best way to protect our assets is to remain cautious and alert. Generally, we should never bet too big on any single trade. We must do what we can to hedge against losses in most cases, and stick to our overall strategy no matter how much the fear of missing out starts eating away at us.

Furthermore, if we are uncertain or unwilling to risk too much, we should never be afraid to ignore crazes and squeezes. Long-term investing—both passive and active—can often get us far better results than trying to rush things, especially since even huge and well-established firms like Apple still likely have ample room to grow.

Historical Example of a Gamma Squeeze 📚

While GameStop and AMC are the most recent and high-profile gamma squeezes, you might be surprised they arguably aren’t the biggest ones in history. During the 2008 financial crisis, Volkswagen was in serious trouble—nearing bankruptcy in fact.

The company was doing poorly enough that it had certain short interest—though at around 12% it wasn’t anywhere near GME levels. This made it ripe for both a gamma and a short squeeze—which is exactly what happened prompting news to report that the short-sellers made VW the world’s most expensive company.

Visual chart describing the Volkswagen squeeze during the 2008 financial crisis
Despite the fact that the Volkswagen squeeze occurred over a decade ago, there are many lessons that day traders may take away from this stock market event.

In fact, Porsche announced unexpectedly that it had raised its stake in Volkswagen to some 74% generating optimism which led to very widespread speculations. In just two days, the VW gamma squeeze drove the share prices up from €210 to more than €1000 truly making the company the priciest in the world despite the dire straits it was in at the time.

According to some sources, various large investors lost a grand total of $30 billion—though it is hard to be completely certain on the numbers considering the squeeze was happening during a global financial crisis. Considering the gravity and shock value of the VW squeeze, there is little wonder it has been used to try and predict the aftermath of the GME/AMC craze.

Final Word: Can You Benefit From Gamma Squeezes? 🏁

Seeing how quickly VW went from €200 to €1000 and GME from $10 to $300, it is blindingly obvious that the brave and lucky traders can benefit immensely from gamma squeezes. However, knowing that the lucky are often also the few, that the market is reeling from inflation and the withdrawal of covid-19 stimulus packages, and is filled with new lockdown-enabled investors and traders, it is generally wiser to learn and practice with safer trades.

Still, the potential of a gamma squeeze can indeed leave you dreaming of going from rags to riches overnight—though if anything this shouldn’t be a call to recklessly chase the next potential GME, but to start learning even more about the market and its workings. Anyone can ultimately end up being among the brave, the lucky, and the few given enough skill and experience.

What is a Gamma Squeeze?: FAQs

  • What Happens During a Gamma Squeeze?

    A gamma squeeze happens when traders’ interest in certain out-of-the-money options goes through the roof forcing the market makers—the ones issuing the options contracts—to buy an increasing number of underlying assets. This, in turn, drives the asset’s price up generating further interest for the options and potentially quintupling the stock’s value as seen with VW in 2008 or even increasing it thirtyfold like in the case of GME.

  • What Happens After a Gamma Squeeze?

    While there are always some losers and some winners of a gamma squeeze in the immediate aftermath, their effects usually aren’t long-term. However, in special cases when the squeeze was particularly dramatic, it can send even large hedge funds into bankruptcy and cause major market chaos at least temporarily.

  • How Long Does a Gamma Squeeze Last?

    Most gamma squeezes are very short-lived. They tend to completely unfold within a few hours or a few days at most. However, there are exceptions to this rule as became evident with the meme stock craze which was in full swing for months.

  • What’s the Primary Difference Between a Gamma Squeeze and a Short Squeeze?

    Generally speaking, a gamma squeeze is caused by a market maker being forced to purchase an increasing number of shares to cover the options contracts it sold. A short squeeze is usually caused by traders purchasing a vast quantity of assets of a certain company. Furthermore, the biggest losers of a gamma squeeze tend to be the market makers, and the biggest losers of a short squeeze tend to be short-sellers. All of that being said, gamma squeezes often happen in conjunction with short squeezes.

  • What is a Gamma Squeeze in Crypto?

    A gamma squeeze in crypto is very similar to a regular gamma squeeze. The biggest difference is that while regular squeezes affect traditional assets like stocks, a crypto squeeze affects the price of a cryptocurrency like Bitcoin or Ethereum.

  • How Does Gamma Change with Volatility?

    When implied volatility decreases, gamma increases and vice-versa. This is because gamma represents the change in the delta which is bigger when implied volatility is lower. On the other hand, when volatility is higher, the change in delta is smaller, and thus, the gamma is smaller as well.

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