We have been seeing lots of action with the GameStop stock going up recently. Since we spoke about short squeezes already, we thought you might want to know about gamma squeezes too. The GameStop phenomenon saw both take place.
What is Gamma?
Gamma is the first derivate of delta; it measures how quickly delta moves. Delta measures the change in an option’s underlying stock price. Gamma is therefore the acceleration by which an option’s underlying stock price moves up or down. Gamma enables traders to identify the volatility of a given option and can thus be used as a tool to hedge against more volatility risk. We dive deeper in the technical stuff below, but let’s first answer what a gamma squeeze is.
This piece on options is a good refresher before going further.
So what about this gamma squeeze ?
A gamma squeeze happens when a big investor uses many options to ramp up the prices of select stocks due to option sellers needing to hedge their trades. The process happens in three general steps: the first part begins when the big investor buys short dated call options very quickly (options of stocks they already own). Then, banks and brokers that sell the call options, will want to purchase the stock back to hedge their position on the call they sold.
The more call options the big investor buys (when you buy the right to purchase a stock at a predetermined strike price later in time), the more shares the brokers will have to buy up to ensure her position is safe. The reason for this is because the broker is trying to neutralize or hedge her gamma exposure (exposure to a fluctuation of an option’s underlying share price). In the end, the option purchases force the dealers to purchase the stock which increases the share price higher yet.
A deeper dive into Gamma:
First of all what does gamma mean ? If you have forgotten the Greek alphabet from your days as a pledge, do not worry, you are not alone. In the context of options trading, gamma is a measure of the convexity (the shape of the curve) of a derivative’s value relative to its underlying stock. In more simple terms, it is how curvy the line is of that relationship. Derivative product like options is pretty much just math, but don’t worry we will keep it more casual and concise:
To understand gamma, the first step is understanding what delta is because gamma uses delta to measure this aforementioned relationship. Delta is the rate of change in an option’s price after the underlying stock has seen a movement in price of say, $1. Imagine an option whose value changes based on the underlying stock price. This very change in price is recorded as delta, as a number between 0 and 1. Gamma is simply equal to the speed at which delta moves up or down. Gamma is the first derivate of delta, and the second derivative of price. Just like in physics, imagine that delta is the speed, and that gamma is the acceleration (you take the derivative of speed to find acceleration in physics).
The larger the gamma, this acceleration in the change of the underlying asset, the more the volatility of the option’s price will be because large changes in prices will energize the desire for traders to move options around. Gamma is useful to have on hand because it signals more precisely the overall trend by which the underlying assets moves. It helps one visualize the risk of trading a certain option but to find gamma is another article altogether.
Risk is important to manage when trading options because it is easy to lose sight of every penny especially when trading large sums in increasingly volatile markets. In order to hedge risk, a trader may buy opposite options (a call and a put on the same stock to break even the expected return). Gamma neutrality, is a tactic that will balance out the swings in those opposite options by adding on more contracts that lock in profits dynamically. Doing this can increase the price of shares, as explored below: