Successfully trading financial markets is all about the successful capture of volatility, no matter its source.

 

A gamma squeeze is the volatility that comes from a complex interaction of financial derivatives pricing and market participant behaviour. The outcome can lead to a dramatic change in market prices.

 

It isn’t just an interesting market phenomenon—large profits can be made from a gamma squeeze. But to do that, the trader must first understand the basics of what leads to a gamma squeeze. 

 

If you are wondering about gamma squeezes and how to spot them, then read on. We’ll go through the fundamentals of squeezes in this post.

 

 

 

A Brief Introduction to Options

What Is An Option?

 

Options are financial contracts that give the holder the right, but not the obligation, to buy or sell a certain asset at a specific price on a specific date in the future. They are often used as a form of insurance, for example, to protect holdings against downside risk. They can be always used to make relatively low-cost but high-leveraged speculative trades by paying what is known as options premium.

 

Options holders are those who own the option and have the right to buy or sell the asset as mentioned above. But options writers are those who provide that right, a fact that will become important in understanding the concept of a gamma squeeze.

 

Options Example

 

Consider the case of a trader that wants to purchase securities worth $2000 for $100 per share. The current price of the security is $110 per share, which means that the trader cannot buy at the price they want. 

 

Instead of waiting for prices to drop before buying (which may never happen), the trader can purchase an option by paying a certain premium, allowing the trader to buy the security for $100 before or on a specified date.

 

The date on which the trader can buy the asset in this example will be specified in the contract, which in turn affects the price of the premium. But whether or not the trader can buy the asset before the specified expiry date depends on whether the options contract is European or American. It doesn’t actually matter where the contract was produced, it’s just the style: American means the holder can exercise the contract on or before the expiration date, whereas European can be exercised only on expiration.

 

 

 

What is Gamma in Options?

One of the 4 options “Greeks” that goes into the pricing of options contracts, gamma puts a number on the rate of change in the delta* value relative to the underlying asset’s price.

*Delta is the rate of change of the price of an option when there is a change in the security price.

 

Gamma Basics

Gamma can be defined as the measure of the increase or decrease in the rate at which the price of an option changes when there is a unit change in the security price. Gamma can be used to depict a change in the option’s value. Gamma can be calculated by using the following formula:

 

 

 

 

Gamma Example

 

Suppose a security has a current price of $100 with a delta of 20 and a gamma of 4. Then in case of a unit change in the price of the security, the delta will change by 4, such that if the value of the security becomes $101, the delta will become 24, and if the value of the security becomes $99, the delta will become 16.

 

 

 

 

What is a Squeeze in Trading?

A squeeze in trading can be understood as a situation that involves certain pressure points building up in the market to such a level that can’t be sustained in more. This market “pressure” comes from the interaction of market participants’ liquidity, e.g. when many or a few larger traders are forced to unwind losses. Such a situation causes immense buying or selling pressure that the available liquidity can’t accommodate, leading to dramatic price changes.

 

Types Of Squeezes

 

There are various types of squeezes in financial markets. The most common types of squeezes are:

 

1. Gamma Squeeze
2. Profit Squeeze
3. Credit Squeeze
4. Short Squeeze
5. Long Squeeze

 

What is a Gamma Squeeze?

A Gamma squeeze is a market condition wherein security prices increase rapidly. This condition is caused by market makers being forced to close out their hedged positions. This causes the security price to increase, and if certain momentum traders latch on to the move as well, prices spiral out of control and rise even further. 

 

Gamma Squeeze Example

 

Consider the case of a security “A”. The current price is $10. A piece of news or even a rumour spreads that the price of security “A”  could be set to increase rapidly.

 

Many traders purchase options in the security within a short period as the security “A” gets purchased in high volume within a short period, and the price of the security increases to $15.

 

When the price reaches $15, many traders get interested and start purchasing the security to make profits. This causes the price of the security to reach $20. Such a situation is known as Gamma Squeeze.

 

Wrapping Up

A Gamma Squeeze is a short-term multi-derivatives market phenomenon that lasts up to a few days maximum.

 

A trader who understands gamma squeezes can even use them to make windfall profits.

 

Bookmap shows you inside the market, and armed with other forms of analysis, aggressive buying seen on the heatmap could be a sign of a gamma squeeze that is happening in real time.

 

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