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Gamma is a second-order derivative of the underlying. The rate of change in delta is known as gamma. In simple words, it is the momentum of the instrument.
After the Gamestop saga, meme stock traders once again took the market makers for a toss, this time with AMC Entertainment. The stock price of AMC entertainment doubled in a single day, creating a short squeeze by market makers who sold options and eventually fell into a gamma trap.
Let us understand what a gamma squeeze is, and how it can lead to wild moves in markets.
Market Type Before we learn about gamma squeeze, we need to understand what kind of market does this study applies to. With options volume being 80%-90% of the overall volume in many instruments nowadays, the theory of options being priced on the underlying may not hold anymore.
In fact, the demand and supply in the options market may lead to wild moves in the underlying. So, for the relationship to hold true, the instrument we would like to track a gamma squeeze on, should be highly liquid in the options market.
Understanding Gamma
Gamma is a second-order derivative of the underlying. The rate of change in delta is known as gamma. In simple words, it is the momentum of the instrument. If the instrument moves slowly there may not be a gamma risk as the short sellers of options will have time to adjust their trades but when the move is fast, it creates a trap leading to a gamma squeeze.
Option sellers are short on gamma and since they hold an unlimited risk profile, this is an important option Greek for them to manage. For example, if a trader sells a call option for 15500 on Nifty and the Nifty immediately moves to 15700 the next day, it will lead to panic by option sellers, and they will jump into square off or adjust their trades leading to further rise in the call option price.
When is gamma active?
One important thing to note is that gamma is related to time and gamma is high only near expiry. The expiry week will have the highest gamma risk as the time is very less for any reversal to happen in the case of a trap. Hence, if looking for a gamma trade, that is the expiry week to trade into.
How does a gamma squeeze happen?
Traders generally tend to copy the consensus trades and due to common trades market-wide, it creates a chained reaction. For instance, when an option seller looks to sell options, the highest open interest strike tends to be of general choice and it increases the quantum in those pivot points.
When these levels are chased and the underlying surpass those levels, it creates panic as there are not enough suppliers to let the option sellers cover their position. This leads to a few choices to option sellers - either increase the price and cover the sold option at any cost or, buy the underlying or, buy some other strike option to cover.
In all cases, it pushes the instrument higher and due to this trap, the prices could climb to any levels without a cap. In the case of AMC Entertainment, the stock doubled in a single day.
How to earn from gamma squeeze
When underlying chases the consensus pivot points of the markets like highest open interest call strike or highest open interest put strike, there is always a marginally higher odds that it may lead to a trap.
Buying single options for those strikes with small stops can be a trading strategy in the expiry week. The risk in this trade is very limited, just to few points of premium loss but if the trade works in favor, in many cases the option prices may double in few hours keeping the reward to risk high in trades.