A gamma squeeze happens when options market makers are forced to buy (or sell) more of an underlying asset due to substantial price changes, creating a cycle that drives the price even higher (or lower). For example, when there is a significant rise in call option purchases, market makers must hedge by acquiring the underlying asset to reduce their exposure. As the price of the underlying asset increases, the delta of the call options rises, requiring market makers to buy even more of the underlying asset to maintain their hedge. This leads to a feedback loop where rising prices result in further buying, which in turn pushes the price up even more. The rapid increase in buying activity can lead to a sharp and sustained rise in the price of the underlying asset—this phenomenon is referred to as a gamma squeeze. Here’s a detailed explanation of the concept:

Options Trading

Options are financial derivatives that give the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price before a specified date. There are two types of options: calls (which grant the right to buy) and puts (which grant the right to sell).

Delta and Gamma

Delta measures how sensitive an option’s price is to changes in the price of the underlying asset. For instance, a delta of 0.5 means that the option’s price will change by $0.50 for every $1 movement in the underlying asset. Gamma measures the rate of change of delta in relation to changes in the underlying asset’s price. A higher gamma indicates that delta is more responsive to price changes in the underlying asset.

Market Makers and Hedging

Market makers are entities that provide liquidity in the options market by buying and selling options. To manage their risk, market makers often hedge their positions by buying or selling the underlying asset.

1. Significant Directional Move: The underlying asset experiences a major move, either up or down. This movement can be triggered by various factors such as news events, earnings reports, or market sentiment.
2. Positive Gamma Exposure: As the underlying asset approaches the strike price of the options that were previously sold or shorted, these options gain positive gamma exposure. Positive gamma means that the delta of the options increases as the underlying asset price moves in the same direction.
3. Rising Delta: With positive gamma, as the underlying asset continues to move in the same direction, the delta of the options keeps increasing. Delta measures the sensitivity of an option’s price to changes in the price of the underlying asset.
4. Hedging Delta Exposure: To hedge this increasing delta exposure, options sellers, including market makers, are forced to buy more of the underlying asset if the price is rising (or sell more if the price is falling). This hedging activity is crucial to maintain a neutral position and manage risk.
5. Self-Reinforcing Cycle: The buying (or selling) pressure on the underlying asset from the options sellers’ hedging activities further fuels the initial move. This additional buying (or selling) drives the price higher (or lower), which in turn amplifies the gamma exposure even more. This creates a self-reinforcing cycle where hedge buying drives up the price, increasing gamma, necessitating more buying, and so on. This cycle can cause the asset price to “squeeze” significantly higher or lower than what fundamentals alone would suggest.

Consider a stock trading at $10, and there is a surge in buying call options with a strike price of $11. As the stock price begins to rise due to demand for the calls, market makers start buying the stock to hedge their short call positions. As the stock price climbs to $10.50, the delta of the call options increases, prompting market makers to purchase even more stock. This can lead to a rapid surge in the stock’s price, potentially pushing it well beyond the $11 strike price.

A gamma squeeze is a phenomenon where positive gamma compels options market makers to aggressively buy (or sell) more delta hedge as the underlying asset trends in one direction. This can result in rapid and exaggerated price movements, causing the asset’s price to deviate significantly from its fundamentals. Understanding the mechanics of gamma and delta, along with the importance of hedging by market makers, is essential for traders to navigate these potentially volatile market conditions.