We discussed how to trade with the smart money by understanding options open interest and max pain here.

Today we will discuss what happens when the smart money is trapped by looking at Reddit’s favorite meme stocks. 

More specifically we’ll talk about how Gamma Squeeze can lead to outrageous volatility. 

Conditions for a Gamma Squeeze

For a Gamma Squeeze to occur, certain conditions must be present. A Gamma Squeeze is a short squeeze but on steroids.

1. First, we need a high short interest in a stock. 

For a squeeze to occur, sure market participants must be stuck, in this case, stubborn shorts. A squeezing stock can continue to do so until stubborn shorts can no longer take the pain and forces out of their position. 

Short interest of over 10% gets my interest, but anything close to 30% or above can fuel a significant move.

       2. Second, we need options activity. 

A Gamma squeeze is also fueled by options activity— this is what gives the short squeeze added “juice”. 

It works like this:  People who are short the stock hedge their positions by buying out of the money call options sold to them by market makers. As we wrote about yesterday the smart money has every incentive to have the options they sold expire worthless to pocket the premium. 

For the most part, they can do this. After all, if they are the house and well, the house should win most of the time. The fun starts when the smart money gets trapped, and a vicious cycle ensues.

A Vicious Cycle

Occasionally when there is so much demand for a stock, market makers who sell options end up fueling the rally. 

Let’s use AMC ENTERTAINMENT (AMC) as an example. AMC had a short interest of around 20% so our first criteria is met.  Now as buying came into this stock a vicious cycle ensued.

Now to help explain this vicious cycle, let’s define the psychology of market participants. Short sellers were short AMC because, in their mind, it was a dying business, and their valuation is at a lower price than where AMC is currently trading. 

Thus as AMC moves higher, they begin to short more as they believe it is going down more over the longer term.

Also, new short-sellers who see AMC going higher pound the stock short because they see the move as irrational expecting it to go down. As we’ve already stated, to control their risk, they buy out of the money calls to hedge their short position. 

So as new shorts enter selling the stock short, there is also added out-of-the-money call buying when the stock goes higher against them.

This is where things can get out of hand. Once the market makers who have sold calls at levels of high open interest can no longer hold the price below that level to collect their premium, they must hedge their short call sales by buying back the stock.

So for example if there is 30k of open interest at $30 calls, once price holds above that level market makers are buying stock to hedge those calls sold. 

But then new shorts come in and buy the $40 calls to hedge. Once price gets above $40 market makers are forced to buy stock to hedge the calls that they sold, sending it even higher.

To add fuel to the fire, you have speculators who understand this rare situation and buy out-of-the-money calls and shares. It puts even more pressure on shorts and market makers— with substantial open interest in calls that cannot be contained for the time being.

This vicious cycle can continue longer than most participants think and usually goes on until a lot of short sellers are forced out of their positions, pushing prices even higher as they cover at any cost or sometimes a hedge fund or big trader blows up. 

Sharks smell blood in the water and usually will not stop until stubborn shorts can no longer take the pain. We have seen occur this in TESLA INC (TSLA) , TILRAY INC (TLRY), BEYOND MEAT INC (BYND),  GAMESTOP CORP (GME), AMC ENTERTAINMENT (AMC) and CLOVER HEALTH INVESTMENT (CLOV) in recent memory  

Bottom Line

Stocks with high short interest can have outsized moves as demand from new buyers fuels added demand from shorts covering. 

These moves can become even more extended as the short squeeze turns into a Gamma squeeze where added demand for stock comes from market makers who are forced to buy even more stock to hedge the calls they sold. 

By understanding these mechanics traders can find good setups during the squeeze and also lower risk by using advanced options strategies.