Most investors want to buy low and sell high. Short sellers try to profit from a price decline by doing the steps in reverse: They sell first and buy later. To short a stock, an investor borrows shares from someone else, sells them at the current market price, and eventually buys them back to return to the lender. If the stock price falls, the short seller can buy the shares back at a lower price and make money. If the stock price rises, the short seller loses money.
Short squeeze
Since a short seller has borrowed shares and could face losses if the price goes up, they usually have to post collateral (sometimes called margin) with their broker. If the stock rises too much, the short seller may be required to put up more collateral or close the position by buying back the shares. When many investors are short the same stock, this can create a feedback loop where climbing prices cause some short sellers to buy shares, that buying pushes the price up further, and the higher price causes more short sellers to buy. This is called a short squeeze. A well-known example occurred in 2021 with GameStop.
Hedging
While many people have heard of a short squeeze, a lesser-known phenomenon is a gamma squeeze. It is related to options and the way option sellers hedge their risk.
A call option gives the buyer the right, but not the obligation, to buy a stock at a specific price (called the strike price) on or before a certain date. For example, suppose ABC stock is trading at $95 per share, and an investor buys a call option with a strike price of $100 that expires in one month. If ABC rises above $100, the call option becomes valuable because it gives the investor the right to buy the stock for less than its market price. If ABC never rises above $100, the option will expire worthless.
The person or firm that sold the call option has the opposite exposure. If the stock rises, the option becomes more valuable, which is good for the option buyer but bad for the option seller. Many option sellers, especially market makers, do not want to make large directional bets on whether a stock will rise or fall. Their business is usually to buy and sell options and earn small spreads. So, rather than simply accepting the risk from every option they sell, they often try to hedge their exposure.
Delta, gamma, and gamma squeeze
One common way to hedge a short call position is by buying shares of the underlying stock.
The amount of stock they need to buy depends on how sensitive the option is to changes in the stock price. In options terminology, this sensitivity is called delta. For example, if a call option has a delta of 0.50, then the option’s price will change by roughly $0.50 for a $1 move in the stock. Since one standard option contract represents 100 shares, an option seller who sold one call option with a 0.50 delta could hedge by buying about 50 shares of the stock.
However, delta does not stay fixed. As the stock price rises, especially when the option is near the strike price or close to expiration, the option’s delta can increase. If the delta rises from 0.50 to 0.70, the option seller may need to buy another 20 shares to remain hedged. The rate at which delta changes is called gamma.
This can become self-reinforcing. If many investors buy call options on a stock, and it starts rising, option sellers may need to buy more shares to hedge their positions. That buying can push the stock price higher, which can increase delta again, requiring more hedging purchases, and so on. This process is called a gamma squeeze.
In tandem
Oftentimes, short squeezes and gamma squeezes happen together because they both have the effect of pushing prices higher. In a short squeeze, short sellers buy shares to close losing positions; in a gamma squeeze, option market makers buy shares to hedge their exposure. When both groups are buying into a rising stock, the demand can feed on itself, creating a sharp upward spiral that may go well beyond what the company’s fundamentals would seem to support.
