The term gamma squeeze has become common in investment circles since the GameStop short squeeze and a subsequent sharp rise in share prices from $5 to more than $500 within just a few days in January.
Like a short squeeze, where a rising share price forces investors who had sold the stock short to buy it back in order to forestall deeper losses, gamma squeeze acts the same way but takes it a notch higher by forcing additional stock-buying activity due to open options positions on the underlying stock.
Gamma squeezes are often associated with options trading and they can be problematic for investors who don’t fully understand how they work. It can happen when there’s widespread buying activity of short-dated call options for a particular stock.
This is a real concern for many retail investors since a gamma squeeze is already behind a large part of the recent meteoric rise in share prices after the Robinhood debacle of mall-based retailer GameStop.
Traders and investors are keenly watching out for the gamma squeeze after recent wild moves in the market, which have drawn parallels to the price action at the onset of the Great Depression.
In GameStop’s case, many people expected the mall-based seller of video games to be forced to declare bankruptcy, thanks to a business model that has been largely disrupted by digital downloads of games.
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When investors expect such bad news, they are tempted to borrow and short the stock. So many people had made that decision regarding GameStop that more than 100 percent of the company’s total float had been sold short at one point.
In this situation, investors bought call options and stocks by the bucketload in an attempt to hedge the stock. But as the stock price soared higher, the market makers – the ones who sold the options – had to buy more stock, resulting in a gamma squeeze.