Previously, we learned about the mechanics and the anatomy of a short squeeze. The gamma squeeze is the short squeeze's cousin, producing similar sharp directional movement in a stock's share prices, but because of completely different reasons. The two squeezes can work in tandem to push a company's share prices to staggering levels.
While a short squeeze manifests itself directly within the equities markets, a gamma squeeze originates from the options markets. Option contracts are derivatives whose prices are tied to the price of the underlying shares that they are based on. We've briefly talked about option contracts in earlier articles, so let's take a deeper dive into their dynamics.
I Had The Option To…
“I had the option to talk to her… but I chose not to.”
At their core, option contracts are pieces of paper that say, “I, the owner of this contract, have the right to buy or to sell some number of shares of a company at a fixed price on or before the indicated date.”
Option contracts come in two flavors, calls and puts.
A call option gives the owner the right, (but not the obligation) to purchase shares of a security at a fixed price before or on a pre-determined date.
A put option works in the same way, but in the opposite direction, affording the owner the right, (but not the obligation) to sell shares of a security at a fixed price before or on a pre-determined date.
The choice that’s afforded as part of option contract differentiates it from a futures contract, in which the participating parties are obligated to either buy or sell the underlying security at the pre-determined date.
*There are two categories of options, American and European. An American option can be exercised at any time, whereas a European option can only be exercised on the expiration date. Most single stock equity options are American, and the examples to follow all refer to American-style options unless otherwise stated.
Each option contract has the following attributes:
Underlying Shares: These are the shares of the company that the option contract is based on. The holder can either buy or sell these shares. In almost all cases, an option contract tracks 100 shares.
Strike Price: The fixed price at which the holder is entitled to buy or sell the underlying shares. For example, an AAPL call option with a strike price of 150 means that the holder has the right to buy 100 shares of AAPL at $150 per share.
An option contract is said to be “in the money” (ITM) when, if it’s a call option, the underlying shares are trading above the strike price, and if it’s a put option, the underlying shares are trading below the strike price. Otherwise, the contract is said to be “out of the money” (OTM).
Expiration Date: All option contracts expire, and the provision, or the “option” to buy or sell the underlying shares at the strike price is only exercisable on or before the contract's expiration date.
Exercise: When an option contract is ITM, the buyer can “exercise” the contract, and, if it’s a call option, buy 100 shares of the underlying security at the strike price, or if it’s a put option, sell 100 shares of the underlying security at the strike price.
Premium: The price of the option contract, which depends on a multitude of factors, including the share price and volatility.
As an aside, an option contract's aforementioned properties mirror those of an insurance contract.
The underlying shares can be compared to the type of insurance being extended, e.g. homeowner's, auto, or health.
An option contract’s strike price is akin to an insurance deductible. An insurance contract does not pay out unless the insured meets their deductible, and an option contract is not exercisable unless the share price meets the contract's strike price.
Both option contracts and insurance contracts have expiration dates. An insurance contract extends coverage for a fixed period, like a year, after which it must be renewed.
We must pay a premium to receive insurance coverage, or to hold an option contract.
Gamma: It’s All Greek to Me
“From alpha to gamma to bad-mama-jamma!” -Will Smith
When trading option contracts, the so-called “greeks” provide good insights into how an option contract will behave. Its pricing is sensitive to
changes in the underlying share prices (delta & gamma),
changes in volatility (vega),
changes in the federal funds interest rate (rho),
the overall passage of time (theta),
and much more.
For example, the delta (∆) of an option contract refers to its sensitivity to price changes in the underlying shares. If an option contract had a delta of 0.47, then the price of the option contract would increase by $0.47 for every dollar increase in the price of the underlying shares.
Gamma (γ), another greek, refers to the sensitivity to changes in an option contract's delta. For the calculus-minded individual, gamma represents the double derivative of an option's price. If an option contract had a gamma of 0.03, using the above example, if the underlying shares increased by $1, then the delta of the options contract would increase from 0.47 to 0.50.
An AAPL call option on Robinhood. The greeks, visible at the bottom, appraise the buyer or seller on the contract’s sensitivity to price changes (delta and gamma), volatility (vega), interest rate fluctuations (rho), and time (theta).
The Other Side of the Trade
“That was a straight line… this is kinked… a very kinky security” -Andrew Lo
The payoff diagram for a call option buyer. The buyer will profit once the underlying security exceeds the strike price, otherwise, their return is 0.
As an option buyer, things feel very clear-cut and deceptively simple. If we buy a call option, and the underlying share price goes up, our call option increases in value and we profit. If we buy a put option, and the underlying share price declines, our put option appreciates in value and we also profit.
Every trade has a buyer and a seller, and the seller of an option contract entertains a whole host of different risks than the buyer of the same contract. A seller of an options contract thinks much like an insurance company. Ideally, they'd love to simply sell the option or insurance contract, collect the premium, and then go out to lunch without having to worry about the contract.
The payoff diagram for a put option seller. The buyer will receive a premium for selling the put option, and will retain the full premium received unless the underlying security moves below the strike price.
When an option is ITM and nearing its expiration date, it is likely that the buyer will exercise the contract. The buyer will elect to either buy (for a call option) or sell (for a put option) 100 of the underlying shares at the agreed upon strike price.
The seller of an option contract undertakes the risk that the buyer will exercise the contract when it's in the money. Hedging away this “assignment risk” is a science in itself, and it’s where major players like market makers and institutions make their bones.
Lower Merion: Mamba Mentality and Market Makers
If my friend had to say the above header three times fast in a job interview… he’d probably be homeless.
Undertaking assignment risk is not for the faint-hearted. It's what makes writing options contracts incredibly capital intensive. This has led to a need for large institutions to step in and provide liquidity. Market makers like Citadel Securities, Optiver, and Susquehanna International Group operate specialized trading desks centered around selling option contracts. Since these market makers have the infrastructure in place to accommodate large trading volumes, smaller broker-dealers will often pass along orders from their clients to these market makers in exchange for a small commission, a practice known as payment for order flow.
Susquehanna International Group’s trading floor in Philadelphia, PA.
When writing option contracts, market makers seek to eliminate any market risk that may arise as a result. For instance, when we sell a put option, we are now bullish on the underlying security, because we will only profit if the underlying security stays above the strike price. Conversely, when selling a call option, we become bearish since we'll only profit if the security stays below the strike price of the option contract.
Market makers will hedge away the market risk from selling an options contract by trading the actual shares of the underlying security as part of a strategy known as “delta hedging”, or being “delta neutral”. Suppose that a market maker sells a call option with a ∆ = 0.16. The market maker can hedge away their market risk by purchasing 16 shares of the underlying security. If the underlying security increases by $1, then the options contract will increase by $16, representing a mark-to-market loss of $16 for the market maker. However, this MTM loss will be negated by the $16 appreciation in the shares that the market maker purchased.
Conversely, if a market maker sold a put option with a ∆ = -0.29 (a put option will always have negative delta), then they could hedge away their market risk by shorting 29 shares of the underlying security.
As an option contract moves closer to becoming ITM, the seller of the contract must either buy or sell more shares of the underlying security to maintain the delta hedge. For example, in our call option example, if the delta increases to 0.36, then the seller of the option contract will have to buy 20 additional shares in order to remain delta neutral. On the other hand, if the delta decreased to 0.05, then the seller would sell 11 shares to maintain the appropriate delta hedge. As mentioned, delta’s variation is reflected in an option contract’s gamma, and as such, dynamically maintaining a delta hedge is referred to as being “delta-gamma neutral”. Delta-gamma neutral portfolios serve as the holy grail for market makers, since achieving such neutrality allows them to trade large option contract volumes without being exposed to any market movements.
Squeeze Play
“Derivatives are weapons of financial mass destruction.” -Warren Buffett
A gamma squeeze produces massive directional movement in an equity when there's a major flow into the associated options contracts for that equity. Let’s take a look into how such a squeeze manifests itself.
Suppose that an investor purchased many OTM call options for a given stock.
The seller of these options (likely a market maker), would need to buy up some of the shares of the stock in order to maintain the appropriate delta hedge.
If the shares purchased is large enough, this will cause an upward movement which will produce a herding effect, resulting in more major market players buying up shares of the stock.
Suddenly, the originally purchased option contracts are much closer to becoming ITM, which means that the contracts have a higher delta.
The original option seller needs to buy more shares to maintain their delta-gamma neutrality.
The cycle repeats.
Executed perfectly, this results in astonishing stock price movements. The gamma squeeze sometimes works in tandem with a short squeeze, moving the stock price to astronomical levels.
In January 2021, we saw truly remarkable price movements in GME stock as part of a short squeeze. After the shares retreated from 483 down to about 50, the stock made another run up to the 300s, a 500% increase, after a mysterious investor purchased a large quantity of call options with a strike price of 800.
A list of the most traded option contracts on GME stock. Topping the list is a weekly call option with a strike price of 800 (which would represent a 300% increase in the stock price). Indicated by the “OInt” column, over 47,000 such option contracts are outstanding.
In 2020, TSLA saw its shares rise considerably. The bull run continued for months, with TSLA blowing past the $500B market cap milestone, issuing a 5:1 stock split, and entering the S&P 500 index during its sustained expansion. Eventually, it was revealed that SoftBank may have induced a gamma squeeze by purchasing more than $2 billion in OTM TSLA call options, fueling the stock's monumental rise.
Abnormally large volumes of OTM TSLA call options with only 9 days-to-expiration traded on August 12, 2020. TSLA was trading at 1500 levels at the time (this was before the 5:1 stock split). Source: @TESLACharts on Twitter
Hundreds of deep, OTM, TSLA call options were purchased only 3 days before their expiration on March 9, 2021, ostensibly to induce some gamma movement. TSLA was trading at 673, and the strikes of the purchased option contracts represented a ~127% increase from its current price levels.
A gamma squeeze doesn't necessarily have to entail a sharp movement in the upwards direction. In 2010, the markets witnessed one of the most sharp and violent intraday movements. Dubbed the “Flash Crash of 2:45”, major market indices fell more than 9% within the span of 15 minutes, only before they just as quickly recouped nearly all of their losses. The exact cause of the drop is unknown, even a whole decade later. However, some attribute the crash to Mark Spitznagel's Universa Investments potentially purchasing a large amount of SPX put options as part of his firm's tail-risk strategy, possibly provoking a gamma movement in the downwards direction.
The intraday Dow Jones Industrial Average chart on March 6th, 2011. The crash, visible on the center-right side of the chart, lasted for roughly 35 minutes.
Your Hazmat Gear: Staying the Course
Gamma squeezes contribute to the volatile and unpredictable financial environment. Just as with the short squeeze, it's nearly impossible to time and trade a gamma squeeze. Observe the squeeze from a safe distance, and look towards total stock market vehicles, which will incorporate any movements from the squeeze in a much more palatable manner.
Excellent post Rohit!