What is a Gamma Squeeze?
Before you find out what a gamma squeeze is, you may wish to learn about the difference between short selling (shorting) and going long. If you have any further queries about how to invest in stocks and how the stock market works, our introductory courses provide great information to set you on the right path.
I. What is a gamma squeeze?
A gamma squeeze is created when institutional investors are forced to purchase a stock to protect their investments.
Institutional investors, such as investment banks and hedge funds, will invest money in the belief that certain stocks will rise in value and certain stocks will fall in value. This is a balanced approach to investing and helps them deal with volatility and risk.
However, if a large group of investors causes the price of the stock to dramatically increase when institutions have invested in the belief that it will fall in value, these institutions are left with no choice but to buy more stock to avoid further losses.
This creates a snowball effect. Those buying the stock ‘chase’ its price as it increases in an attempt to get involved in the growth, and this in turn forces institutions to chase the price upwards too so they can minimise losses. These two buying forces create increasing momentum as the share price snowballs.
II. How exactly do gamma squeezes work?
Gamma squeezes drive the value of a particular stock up dramatically.
Gamma squeezes cause the price of a stock to rise exponentially. When stocks usually rise in price as the result of a bull market, it can be the result of promising quarterly results, a business merger, or some other form of positive news. However, a gamma squeeze is a phenomenon that doesn’t require any kind of logical basis.
Institutional investors have a strong grip on the market and deploy complex strategies to gain maximum exposure to returns whilst mitigating the impact of risk. One of these strategies is as follows:
These institutions will go both long and short. For certain stocks, they will buy into an increasing price, which is going long. However, to protect their investment portfolio from broader market trends, they invest in the belief that a company in the same industry will fall in value, which is going short (shorting).
If they invest in two different car companies, with one long position and one short position, there is the potential that their long position will increase in value, and if the wider automotive market moves against them, their short position will consolidate their losses. This balanced approach is known as being market neutral.
If a group of investors then start to buy the shorted stock, the value is driven up by increased demand. These institutions must act to protect their investments, and demand to buy the stock increases further, resulting in an even more drastic price increase.
III. What is the difference between a short squeeze and a gamma squeeze?
There are slight differences between short squeezes and gamma squeezes, but the main premise is the same.
Gamma squeezes are more intense than shorts squeezes. They create additional stock-buying activity due to open options positions on the underlying stock. For traders, the ‘delta’ indicates the number of options that are needed to hedge (protect) a long or short position, and the ‘gamma’ refers to the amount of volatility. Institutional investors aim to reduce the gamma so they can operate effectively over a wider price range.
IV. How can you spot a gamma squeeze?
Gamma squeezes can be quite easy to spot, but you need to know what you are looking for.
Because gamma squeezes are caused by technical factors in the market rather than underlying fundamentals, you should focus on technical analysis as opposed to fundamental analysis. If you spot an unnatural price increase, such as the market performance of GameStop (NYSE: GME) in January 2021, be sure to read the latest market news and analysis to see if there is any coverage about the stock that can inform you.
Investing forums have become increasingly popular in recent years, and these can be a good source of information so you can get involved early. However, they can also be a source of misinformation, so remain cautious. Such forums have been involved in gamma squeezes before, like Gamestop’s (link to WallStreetBets article), and we expect this trend to continue.
V. Is gamma squeezing a good trading strategy?
Gamma squeezes can potentially deliver big returns, but they can create a lot of volatility.
If you can spot a gamma squeeze happening in its early stages, you could potentially open up a buy position and see your investment skyrocket in value. To open a position, you will need a trustworthy stock broker with a good reputation. We have reviewed all of the top stock brokers, and this may be useful for you.
However, make sure you understand gamma squeezes fully before taking the plunge. Investors can sometimes misidentify a gamma squeeze based on speculation and end up purchasing overpriced stock.
Gamma squeezes are viewed by some as an effective tactic to combat the strong positions that institutions hold in financial markets, but you should remain aware that all these institutions are working just as hard to maintain their strength. As such, gamma squeezes create lucrative, high-risk, high-reward investment opportunities.