05/15/24 09:06 AM EDT

Market Situation Report Education: Gamma Squeeze

Below is a chart and brief excerpt from today’s Market Situation Report written by Tier 1 Alpha. If you’re interested in learning more about the Hedgeye-Tier 1 Alpha partnership, there’s more information here.

Thanks to GameStop, CNBC has dusted off an old favorite headline, the Gamma squeeze. What is it? Let's talk about it.

A gamma squeeze occurs when the gamma exposure of market makers and other options sellers becomes very positive due to a large move in the underlying asset.

Here's how a gamma squeeze can unfold:

The underlying asset makes a large directional move, either up or down.
This causes the options that were previously sold/shorted to gain positive gamma exposure as they move closer to the money..
With positive gamma, as the underlying keeps moving in that direction, the options' deltas keep increasing.
To hedge this increasing delta exposure, the options sellers are forced to buy more and more of the underlying asset.
This buying pressure on the underlying then furthers the initial move higher (or lower), increasing gamma even more.
This creates a self-reinforcing Loop of hedge buying driving up the price, increasing gamma, requiring more buying, etc.

The gamma squeeze gets its name from the positive gamma forcing options market makers to aggressively buy more delta hedge as the underlying trends in one direction. It can exacerbate volatility and make the underlying asset "squeeze" even higher or lower than fundamentals may suggest.

Avoiding excessive negative gamma risk helps market makers prevent being caught in these self-reinforcing squeezes.