Wall Street traders are witnessing one of the craziest battles in years as GameStop (NYSE: GME) and other heavily shorted stocks continue to experience breathtaking volatility due to a “David and Goliath” war between hedge funds and a growing community of day traders on social media website Reddit.
Shares of GameStop have skyrocketed to unbelievable levels in January — its market capitalization as of this writing is $18.41 billion — fueled by social media chatter that sent shares of the company up by 1,000% over the past two weeks.
On Jan. 4, GameStop shares had been worth just $17.25. But in recent days, the stock has spiked more than 500%.
Early in the rally, the horde of day traders identified GameStop short-sellers as their primary enemy, hoping to earn profits by forcing the sellers to cover their positions.
But this crazy trading action has little or nothing to do with the long-term future of money-losing GameStop and other stocks like BlackBerry (NYSE: BB), AMC (NYSE: AMC), and Virgin Galactic (NYSE: SPCE).
Analysts have described this epic short squeeze in stocks with high short interest as a “gamma squeeze.”
But before going further, let’s first remind ourselves what a short squeeze is.
A short squeeze refers to a market inefficiency where shares of a heavily shorted stock rise rapidly because there are not sufficient shares outstanding to be sold to new buyers.
A short position is basically a way for traders to bet that a stock will fall. Traders borrow shares from a brokerage firm or another trader and sell them in the stock market.
If the price of the stock goes down, they buy back the shares and use them to settle the debt with the lender, pocketing the difference as profit.
Now, let’s move on to gamma squeeze.
What is a Gamma Squeeze?
A “gamma squeeze” is a trading terminology that refers to massive call buying leading to higher stock prices, which leads to more call buying, a higher stock price and so on.
Calls, a form of option, increase in value when the price of the underlying stock increases.
For a gamma squeeze to start, a group of small retail traders or one big trader betting that a stock will rise buy short-dated call options in the underlying stock.
Once they buy these call options, the investment banks and intuitional investors that sell them essentially become short the underlying stock.
For instance, traders on the Reddit’s WallStreetBets forum encouraged each other to buy large volumes of GameStop call options at much higher prices than where its stock was trading, also known as deep out-of-the-money, which have very low premiums.
Should the traders buy more call options, market makers and institutional brokers will be forced to buy more shares of the underlying stock to hedge their short position.
If the calls find themselves “in-the-money”, market makers will be able to offset their loss.
Just like a short squeeze, as the price of a stock begins to go up and traders increase their call positions, market makers are forced to buy the underlying the stock thus pushing its price higher.
Investors selling or writing the call are hoping the price will fall, but like going short, the downside can technically be limitless because the stock can keep on climbing instead of dropping to zero.
If a stock has low liquidity, the latter can cause the share price to rise even further, forcing brokerages to purchase even more shares as the value of their exposure increases further as the share price gets closer to the strike price of call options.
This relationship creates the what is known as a “gamma squeeze,” a phenomenon that can leave some investors with massive losses.
For example, two hedge funds that had placed bets for shares of GameStop stock to slump have thrown in the towel.
One, Melvin Capital, has closed out its short position in GameStop, with manager Gabe Plotkin telling CNBC that the hedge fund was taking a huge loss.
As a result, its backers Point72 Asset Management and Citadel, have now injected roughly $3 billion into the firm to keep it afloat.
Citron Research also announced in a YouTube video that it has closed out of most of its GameStop short position “in the $90s at a loss 100%.”
Gamma, Delta Relationship
Now, you may probably have heard about these Greek letters but maybe you don’t know exactly what they are or how they are related to gamma squeeze.
These Greeks refer to simple concepts that can help traders to better understand the potential reward and risk of an option position. They show how sensitive an option is to movements in the price its underlying stock, changes in implied volatility, and time-value decay.
Let’s discuss the relationship between gamma and delta.
Delta measures the rate of change of the options price per the change in the underlying stock price. A delta of .40 means the option price will increase 40 cents for every $1 in the stock.
Delta does not change proportionately with the price of a stock because it is a nonlinear function.
Gamma measures how Delta will change as the stock changes in price. Simply put, gamma tells traders how much the option’s delta should change as the price of the underlying stock rises or falls.
In most cases, an option premium is a small fraction of the price of the underlying stock. But if an option is in-the-money at expiration, its holder takes delivery of the underlying shares and has to pay fully for the shares. However, options traders often roll the option to a future month or sell it to avoid payment.
A gamma squeeze can be a source of significant volatility and instability that is worth exploring.
The ideal stocks for a gamma squeeze are those of companies like GameStop, which are heavily shorted by institutional investors and hedge funds.
This type of squeeze relies on the hedging actions of short sellers.
The investment banks and brokerage firms who are the largest sellers of options have to hedge their positions. They frequently adjust the hedge amount according to the delta of the option.