Following the debacle regarding Gamestop, meme stock traders again decided to trip the market makers. This time around, AMC Entertainment was up for a toss. The stock price of AMC entertainment doubled in a single day, which created a short squeeze by market makers who sold options and eventually fell into a gamma trap.
Here is a guide to what a gamma squeeze is, and how it can lead to crazy moves in markets.
Prior to learning anything about gamma squeeze, it is crucial to understand what kind of market can this study be applied to. With the options volume being 80%-90% of the overall volume in many instruments these days, the theory of options being priced on the underlying may no longer hold true.
In fact, the demand and supply in the options market may lead to very irreverent moves in the underlying. Thus, for the relationship to hold true, the instrument we want to track a gamma squeeze on should be highly liquid in the options market.
Gamma is a second-order derivative of the underlying, and the rate of change in delta is known as gamma. In simple words, it is the momentum of any instrument. If the instrument moves slowly, then there may not be a gamma risk as the short sellers of options will have time to adjust their trades. However, when the move is rapid, it creates a trap that leads to a gamma squeeze.
Option sellers are short on gamma. Since they hold an unlimited risk profile, this is an important option for them to manage. For example, if a trader sells a call option for 15500 on a Nifty which immediately moves to 15700 the next day, it will lead to panic among option sellers. Consequently, they will jump into square off or adjust their trades. This will lead to a further rise in the call option price.
It is important to keep in mind that gamma is related to time and gamma is high only near its expiry. The expiry week will have the highest gamma risk as the time for any reversal to happen in the case of a trap is very less. Hence, if you are looking for a gamma trade, the expiry week is when you should begin trading.
When underlying chases the consensus pivot points of the markets, such as highest open interest call strike or highest open interest put strike, there are always some marginally higher odds that it may lead to some sort of a trap.
Buying single options for those strikes with small stops might be a useful trading strategy, but only in the expiry week. The risk in this trade is very limited to just a few points of premium loss. However, if the trade works in your favour, as it does in many cases, the option prices may double in a few hours, keeping the reward to risk high in your trades.