In January 2021, the stock of video game retailer GameStop Corp (NYSE:GME) captured the world’s attention as it experienced a rare short squeeze. This event saw the price of GME rapidly increase over 2,500% in less than three weeks. Around the same time, several other stocks with similar characteristics found popularity with online communities such as Reddit’s WallStreetBets subreddit. Some of these also saw swift and dramatic price increases. Perhaps the most notable among them was movie theater chain AMC Entertainment Holdings (NYSE:AMC).
The intense price increases put a new spotlight on the stock market and drove a large increase in retail trading. Thousands of individual investors piled into a situation they may not have fully understood. The trading frenzy prompted an interesting reaction from some social media platforms as they attempted to crack down on what they saw as misinformation. The trading activity even drew the ire of politicians, and famously caused brokerages to restrict trading.
There were multiple factors that drove the waves of rapid price movement. The first wave was a classic short squeeze, but options traders played their part in the second wave by creating a gamma squeeze.
A short squeeze takes place when the rapid increase of a stock price forces investors who sold that stock short to buy back those shares. If there are a large number of short sellers closing out their positions, this drives the prices of the stock higher even as more buyers are drawn in by the rapidly rising price. For short sellers it is a vicious cycle to the upside.
A gamma squeeze is a similar situation, but instead of being driven solely by the stock price, a gamma squeeze is driven by option activity. In the case of GME shares, the highly visible short squeeze was followed up shortly after by a gamma squeeze.
Often, because of short squeeze potential, investors who sell short a stock will cover their short position by buying long, out-of-the-money call options. As GameStop’s share price rose, more short-sellers sought to take advantage of the stock’s predicted fall, in turn hedging their short position through the purchase of more out-of-the-money call options. Additionally, speculators continued buying short-term out-of-the-money call options, betting that the GameStop share price would continue to rise.
As more out-of-the-money call options were traded, market makers on the opposite side of those trades had to buy shares of the stock to hedge their own position. This caused the stock price to rise rapidly in a second wave of price increases.
Gamma, as a measure of option price acceleration, is the variable that describes the effect of a rapid price rise in options. That’s where the situation gets its name. A gamma squeeze is what helped accelerate the GameStop rally in February and the AMC price increase in June.
In the GameStop situation, as the squeeze unfolded, the price of both the stock and options on the stock became incredibly expensive. This started to price out retail traders who had previously been piling on in droves. Once momentum slowed, so did the price of options. This meant the market makers who had bought shares of the stock to hedge their positions no longer required them and could sell, which put downward pressure on GameStop’s share price for a time.
It is interesting to note that the price of GME shares fell below $40 per share in early February after the short squeeze. However, after the gamma squeeze a few weeks later, the price of the shares has averaged well over $100 per share, suggesting that investors do indeed like the stock.