Gamma squeezes: How Do they Dramatically Affect stock prices

Spark Global Limited reports:

As GameStop(NYSE :GME) and other heavily shorted stocks continue to experience spectacular volatility amid the “David versus Goliath” war between hedge funds and a growing number of day traders on social media site Reddit, Wall Street traders are witnessing one of the craziest battles in years.
GameStop’s stock soared to incredible levels in January — at the time of writing, it had a market cap of $18.41 billion — and the buzz on social media has pushed the stock up 1,000 percent over the past two weeks. On Jan. 4, GameStop’s stock was trading at $17.25. But in recent days, the stock has risen more than 500%.

In the early days of the rally, a large number of day traders saw GameStop short sellers as their main enemy, hoping to profit by forcing them to cover their positions.

But the frenzied trading activity has little to do with the long-term prospects of money-losing GameStop and other stocks like blackberry (NYSE: BB), AMC (NYSE: AMC) and Virgin Galactic (NYSE: SPCE).

Analysts call this epic short squeeze on stocks with high short interest rates the “gamma squeeze.”

But before we go any further, let’s remind ourselves what a short-term squeeze is.

Squeeze refers to a market inefficiency situation in which the price of a heavily shorted stock rises rapidly because there are not enough shares outstanding to sell to new buyers.

Short positions are basically a way for traders to bet that a stock will fall. Traders borrow shares from brokerage firms or other traders and sell them on the stock market.

If the share price falls, they buy back the shares and use them to settle the debt with the lender, pocketing the difference.

Now, let’s look at the gamma squeeze.

What is extrusion?
A “gamma squeeze” is a trading term that refers to heavy buying of call options leading to higher stock prices, which in turn leads to higher stock prices, and so on.

A call option is a form of option that increases in value when the underlying stock rises in price.

If a gamma squeeze starts, a group of small retail traders or a large trader bets that a stock will rise and buys short-term call options on that stock.

Once they buy those calls, investment banks and gut investors essentially short the underlying stock.

For example, traders on Reddit’s WallStreetBets forum encouraged each other to buy large amounts of GameStop call options, also known as “deep out-of-the-money options,” at a very low premium, at a price well above where the company’s stock was trading.

If traders buy more calls, market makers and prime brokers will be forced to buy more of the underlying stocks to hedge their short positions.

If calls find themselves “paid out”, market makers will be able to cover their losses.

Like a short squeeze, when a stock’s price starts to rise and traders increase their bullish positions, market makers are forced to buy the underlying stock, pushing up its price.

Investors who sell or write call options hope the stock price will fall, but like shorting, technically the fall can be unlimited because the stock can continue to climb rather than fall to zero.

If a stock is less liquid, the latter can cause the price to rise further, forcing the broker to buy more shares as the value of the exposure increases further as the stock gets closer to the strike price of the call option.

That relationship has led to a phenomenon known as the “gamma squeeze,” which can leave some investors with big losses.

For example, two hedge funds that had bet that GameStop’s stock would collapse have thrown in the towel.

Melvin Capital has closed its short position in GameStop, and Gabe Plotkin, a manager at Melvin Capital, told CNBC that the hedge fund had suffered significant losses.

As a result, its backers, Point72 Asset Management and Citadel, have now pumped about $3 billion into the company to keep it afloat.

Citron Research also announced in a YouTube video that it had closed most of its short positions in GameStop, “at a 100% loss over $90.”