This article assumes a basic understanding of what options are, if you need a quick breakdown you can read up on them here. A gamma squeeze is a rapid rise in price caused by sellers of option contracts having to hedge against the risk of the contract exercising by buying the underlying asset. This drives up the price of the asset as the buying pressure on it increases causing more contracts to need hedging. A feedback loop that keeps forcing the price up to a point where the contracts are sufficiently hedged.
In the case of GME, to understand which contracts will most facilitate a gamma squeeze you need to understand the mechanics of a gamma squeeze and who is selling you these contracts.
Who Is Selling Me Options?
Unlike when trading normal stocks, when you buy an options contract you usually aren’t trading with another individual investor, but rather a market maker. This is an important detail as market makers when selling contracts use a sophisticated pricing model called the Black-Scholes options pricing model. They use this model to figure out the price the contract should trade at and then factor in an additional premium to claim a profit on the trade.
Along with helping to model a price for the option contract, the Black-Scholes also models the risk associated with the contract position. Market makers use this to understand how to hedge their position based on the Greeks. The Greeks are a set of variables that help measure the sensitivity of an option’s price to various factors. But to understand a gamma squeeze you only need to focus on two of the Greeks – Delta & Gamma. (Explained Below)
Mechanics Of A Gamma Squeeze
To understand gamma, you first need to understand delta. Delta is the expected change in price of an option from a change in the price of the underlying asset. So, if a call option had a delta of 0.3, the price of the contract would be expected to rise $0.30 for every $1 the stock’s price increased. Delta changes depending on how close or far away a stock is from it’s strike price, this is illustrated in the graph below.
In the above graph you can see delta is flat at or near zero as the price of the stock is far below the strike price and it is flat and high as the stock price is far above the strike price. This is intuitive as if you’re really far away from being in the money, a dollar increase in stock price isn’t going to make the option that much more valuable. And if you’re very far above the strike price a dollar increase in the stock price is worth pretty much an extra dollar per share when exercised.
But what is worth noting is the steepness of the line as it approaches the strike price. This is when delta rapidly starts increasing and the line is at it’s steepest at the strike price. Gamma is the rate change of delta and is represented by the steepness of the line in the above graph. So, in turn gamma is at it’s highest as a contract is at it’s strike price. And very high when it is near it’s strike price.
What Does This Mean For GME?
Market makers use gamma to understand how much to hedge their position. As gamma rapidly begins to increase market makers are forced to start buying the underlying asset (or GME in the case of GME calls). So to see the greatest increase in gamma the price would have to approach the strike price. This makes the most valuable options in initiating a gamma squeeze those with a strike price near or slightly above the current market price. A high volume of call contracts purchased at this price range is more likely to initiate a gamma squeeze than buying calls far out of the money.
This also means that trading in your very in the money calls for calls that are far out of the money may likely reduce the chances of a squeeze. This is based on a separate but similar principal called delta hedging. If you have a call you bought on GME early with a strike price of 60 and now the price of GME is over 100, the delta on this contract is very high. If you then decide to sell this contract and buy a cheap out of the money call with a strike price of 150 or 200 hoping to make money on a rapid rise, you will then have given market makers the chance to buy back your in the money contract. And now you will own a contract with a much lower delta.
Similar to gamma hedging, how high delta is plays a role in how much market makers will have to buy the underlying asset to manage their risk. And by trading your in the money contracts for out the money contracts, you will be lowering the delta and essentially the amount market makers will have to hedge by (the amount of GME they will have to purchase).
When analysing the first GME squeeze with the price movement of GME now, this is the first time the price movement shows the chance for another potential squeeze. With high short interest, the price of GME sustaining a high long enough to increase borrowing fees significantly and the rise in price again coming off the back of a gamma squeeze.
However when compared to the climax of the first squeeze, borrowing fees are still low and the daily price movement rather resembles the price movement of GME during it’s build up to the first squeeze. In which we saw a slow rise in price and a slow increase in borrowing fees both accompanied by multiple gamma squeezes. The first forcing the price up from 20 to almost 50, the second shooting the price close to 100 and then two more proceeding the climax in late Jan / early Feb.
Regardless for people betting on another short squeeze it is important to understand how the options market will effect price movement as these variables are very likely to be the catalyst for another short squeeze if it does occur.