Gamma squeezes can benefit traders under certain market conditions. They can also be risky, as price fluctuations can be sudden and drastic. Whether you’re new to trading or a seasoned investor, understanding the fundamentals and potential risks of gamma squeezes and indices trading is essential for success. In this article, we’ll explore the basics of gamma squeezes and how you can use them to maximize your gains.
What is a gamma squeeze in trading?
It's a term used to describe a sudden and significant increase in the price of a stock. It’s caused by a surge in demand from options traders. A gamma squeeze occurs when the price of a stock rises.
Market makers who have sold call options on the stock must buy shares to hedge their exposure, driving up the stock price. To understand how a gamma squeeze works, you need to understand a few key concepts.
When an investor buys a call option, they’re purchasing the right to buy a stock at the strike price, within a certain period – the expiration date. If the stock price rises above the strike price, the option becomes more valuable. The holder can buy the stock at a discount and then sell it at a higher market price.
What is a market maker?
Market makers are financial institutions that facilitate options trading by buying and selling options contracts. When these institutions sell call options, they’re betting that the stock price will not rise above the strike price. This allows them to keep the premium paid by the option buyer. If the stock price rises above the strike price, the market maker must buy shares of the stock to hedge their exposure. It may be necessary for them to sell the stock at a lower strike price.
In a gamma squeeze, the market maker sells many call options on a stock. These types of transactions create a large short position. If the stock price rises above the strike price, the market maker must buy shares to hedge their exposure.
As more investors buy call options and the stock price rises, it forces the market maker to buy more and more shares. These transactions drive up the price of the stock.
What gamma squeezes mean for investors
Gamma squeezes can have significant implications for investors who hold short positions in the affected stock. Continued pressure could cause large losses for these investors. Buying pressures can push the stock price higher and benefit long positions.
To mitigate the impact of a gamma squeeze on a portfolio, investors may wish to hedge their positions. This could involve buying options on the affected stock to help diversify the investor’s portfolio to reduce their exposure to any stock or market.
Final thoughts
Market developments and trends are important for investors and traders to help them adjust their strategies to stay ahead of the curve. With the right approach and a bit of luck, investors are able to navigate even the most challenging market conditions and come out ahead in the end.
(The views expressed by the author in this article are personal and do not reflect those of Connected to India.)