Tuesday , 17 May 2022

What Are Short & Gamma Squeezes? How Do They Work?

Short and gamma squeezes will remain a big story in the financial news media until heavily shorted stocks that have been pushed up by individual investors connected through social media sites such as Reddit’s WallStreetBets come crashing back to earth.

By Lorimer Wilson, Founder & Managing Editor of munKNEE.com and a frequent contributor to eResearch.com, usfinancepost.com, bitgrum.com and talkmarkets.com.

What Is a Short Squeeze?

Institutional investors (hedge funds and the like) short stocks with the full expectation that the price of those stocks will drop in price going forward and that they will eventually reap major profits as a result. Small retail investors, on the other hand, intend to make these large institutions and billionaire speculators regret their decisions by driving the stock prices of these stocks higher.

If the price of the stock rises enough the short seller’s margin will decline to the point where the investor will receive a margin call and then either have to take a loss (i.e. close their short position) by buying back those shares or by doubling down on their investment. That’s what is called a short squeeze and when that happens the price of the stock is pushed even higher.

In summary, a short squeeze is when there is strong demand for a stock that also has a lot of short-sellers that forces short sellers to buy the stock in an attempt to cut their losses. When this happens – when both the long buyers and the short sellers are buying – it drives the price up even further.

How Do You Short A Stock?

If you believe a stock’s value will increase over time, you want to buy it and hold it, which is known as taking a “long” position but, if you anticipate that a stock’s price will decrease, you could take a “short” position.

To do this, you would borrow shares of the stock on margin and sell them to another investor (even though you don’t own them) at a higher price to cover the interest on what you have borrowed and then wait for the stock price to fall as anticipated BUT, if the stock’s price keeps rising, though, you would have to rebuy the borrowed shares at a higher price than what you initially sold the shares for.

Which Stocks Are Being Short Squeezed?

Go here for a list of the companies with the largest proportions of outstanding shares currently sold short.

What is a Gamma Squeeze?

A gamma squeeze involves options contracts that directly impact the underlying stock and a gamma squeeze coupled with the classic short-squeeze can enable retail traders to force those in a short position to capitulate.

Gamma squeezes can offer a unique opportunity to investors and traders, but there’s a significant amount of risk involved. For this reason, timing is very important since the gamma squeeze can cause stock prices to drop sharply when they move in the opposite direction.

How Does A Gamma Squeeze Work?

When there’s large-scale buying of call options of the underlying stock, institutional investors will end up selling options in a short position and, this might force them to put more money into shares of the stock to ensure that they have very little or no net exposure but it forces more buying activity, pushing the stock price up further. That’s how a gamma squeeze works.

Since gamma squeezes are not sustainable for the long term, timing is paramount as prices can rise sharply within a short period, and price reversals can also happen quickly. When stock prices reverse, the move in the opposite direction can lead to massive losses.

Conclusion

A gamma squeeze can offer a significant opportunity for out-sized gains for investors but it is risky as timing is critical as share prices can be extremely volatile.

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