gamma compression | How open options can cause stock price spikes

Gamma compression can dramatically affect a company’s stock price – Photo: Katjen/Shutterstock

A gamma compression can be a rather mysterious concept for many investors, but it can significantly affect a company’s stock price over very short periods of time. It is best described as an investment term for a very rapid rise in the stock price triggered by the market’s reaction to large trading volumes in one direction.

But does this make it an advantage for an investor or can it threaten the stability of their overall portfolio?

Here we take a closer look at what gamma compression means, what triggers one, the impact it can have on your holdings, and how long it typically lasts.

Why do people talk about gamma compression?

Although a gamma squeeze is a common term among professional investors and traders, it has recently become more common. This is largely due to the more widespread sharing of information online, according to Danni Hewson, financial analyst at AJ Bell.

“Short selling, meme stocks and gamma press have become the talk of dinner parties over the past two years as social media creates a platform for discussion and bragging,” she said. at Capital.com.

Hewson likened it to when the emergence of cryptocurrency millionaires sparked “a buying frenzy” among a new generation of investors.

“Family names suddenly reaching unsustainable heights in share prices have captured people’s imaginations – but this kind of market manipulation is child’s play if you’re not in the know and will attract scrutiny. careful on the part of regulators,” she warned.

What is gamma compression?

So what is stock gamma compression?

Gamma compression occurs when stocks rise very sharply as market makers need to close their positions on the back of large trading volumes. This occurs when investors are forced to buy a stock due to a large change in its price. Due to this increased demand, the stock price rises sharply.

Market makers writing options may have to deliver that underlying stock. In order to limit their exposure to risk, they often buy or sell shares of this company.

A call option offers investors and traders the chance to buy a stock at an agreed price within a specific time frame. This gives them a degree of certainty as they will know what the costs will be if they find themselves in such a scenario later on. However, when there is a rather excessive demand for these call options, a so-called gamma compression can take place.

So how does gamma compression differ from short compression? Although the concepts are similar, short squeezes happen to traders, not market makers. When stock markets move rapidly in response to large trades in a particular direction, traders may be forced to exit their positions.

This may require them to sell stocks or add additional funds to their trading accounts. Again, these changes in demand and selling patterns can cause stock values ​​to skyrocket.

Gamma Squeeze explained: Why is this happening?

According to AJ Bell analyst Danni Hewson, gamma compression is “a complicated scenario” that most retail investors would do well to avoid.

“If traders are running out of stocks because someone bought call options, that could create a scenario for gamma compression,” she said. “The price goes up and the more the stock goes up, the more traders have to close their positions, which creates more buying, etc.”

Of course, there is a clear problem with this scenario. This is a situation that investors need to recognize, as it can hurt a company’s valuation.

“There is nothing behind the surge in stocks but thin air and when the air stops swirling the stock plummets, leaving many who had hoped to jump on the bandwagon a few horsepower,” said she added.

Gamma Compression Indicator: What Causes High Trading Volumes?

Trading will be affected by views and opinions. These can be based on anything from particular world events to rumors spreading online.

In recent years, message boards have become an influential driver of certain stocks, especially new companies that are not closely followed by analysts. Reddit, the innovative website that allows people to create their own communities of specialists online, has become a particularly popular destination.

The posts have generated excitement for relatively unknown companies that are tipped for big things. However, it is essential that you do your own research into such claims.

Reddit’s WallStreetBets forum has 12.5 million members and has been credited with influencing the stock prices of companies such as GameStop (GME) and AMC (AMC).

Gamma Compression Options: What is an option and how does it affect price gains?

A call option is best described as a contract that gives the buyer the right to buy an agreed amount of an underlying asset at a set price for a certain period of time. A put option gives its holder the right to sell a defined amount of an underlying asset at a specified price within a specified time.

As noted, gamma compressions are often associated with options trading. For investors who don’t know how they can work, there are many potential dangers. They can cause sharp spikes, followed by equally rapid drops.

Whether or not you can benefit from gamma compression depends on the moment. If you do it right, you could be in the money. If you are wrong, you could suffer losses. Trading gamma compression is unpredictable and very difficult to get right. Anyone operating in this area must be prepared to bear high levels of risk.

How it can cause meteoric rises in stock prices

An example of gamma compression came in June 2021 when shares of AMC Entertainment Holdings hit an all-time high. The stock price stood at $12.08 on May 21, 2021, but by June 2 it had risen to $62.55. This represented an incredible increase of 418%.

This impressive rally was partly attributed to heavy trading in stock options that give buyers the right to buy or sell stocks at a fixed price in the future. AMC gamma compression is an illustration of how prices can rise in response. For investors who buy and sell at the right time, there are handsome profits to be made.

Another example came with GameStop, the video game retailer. Its stock soared 400% from $16.25 on January 18, 2021 to $81.25 just seven days later on January 25. According to analysts and industry watchers, a gamma squeeze from call options trading was the most likely explanation for the rapid rise.

FAQs

What triggers gamma compression?

When investors are forced to buy a stock due to a change in its price, it can lead to a spike in the price of the stock. Traders buying call options can create risk for market makers. When a stock goes up, market makers may be compelled to buy the underlying stock, fueling a rally.

How does a stock go up with gamma compression?

Traders needing to buy the underlying stock lead to an increase in demand. When demand increases for an asset, its price will subsequently increase.

What happens after gamma compression?

It’s not fixed. The concern is that once a gamma compression hits its peak, fortunes can quickly turn. This can mean that the stock price is falling as quickly as it rose. This can leave investors with losses.

Further reading

Karen J. Nelson