Have you ever heard the term “gamma squeeze” and wondered what it means? Don’t worry! We’re here to explain this interesting stock market concept in a way that even a 5th grader can understand.
First, let’s talk about something called “options.” Options are like “special tickets” that people can buy in the stock market. These tickets let people either buy (call options) or sell (put options) a stock at a certain price for a limited time. People buy options to make bets on whether a stock’s price will go up or down and others sell options to generate premium income in the belief that the stock will not go up or down more than the “strike price” of the contract.
Next, let’s talk about “Delta” and “Gamma.”
These are two important concepts in the world of options trading, which we mentioned earlier is like buying special tickets to either buy (call options) or sell (put options) a stock at a certain price for a limited time. To make it easy for a 5th grader to understand, let’s use an example.
Imagine you have a special ticket (call option) that lets you buy ice cream for $5 anytime in the next month. Now, let’s see how Delta and Gamma come into play.
Delta
Delta is like a measuring stick that tells us how much the value of our special ice cream ticket (option) will change when the actual price of ice cream changes. If the Delta of our ticket is 0.5, it means that if the price of ice cream goes up by $1, our ticket will become $0.50 more valuable. On the other hand, if the price of ice cream goes down by $1, our ticket will become $0.50 less valuable.
So, if the ice cream price goes up from $5 to $6, our ticket would now be worth $0.50 more because of the Delta. The Delta helps us understand how the ticket’s value is connected to the ice cream price.
Gamma
Now let’s talk about Gamma, which is kind of like a speedometer that shows how fast Delta is changing. Remember how we said Delta tells us how much our ticket’s value will change when the ice cream price changes? Well, Gamma tells us how much Delta will change when the ice cream price changes.
Let’s say the Gamma of our ice cream ticket is 0.1. If the ice cream price goes up by $1, not only will our ticket become $0.50 more valuable (because of Delta), but Delta itself will also change. In this case, Delta would increase by 0.1, from 0.5 to 0.6.
Now, if the ice cream price goes up another $1 (from $6 to $7), our ticket will become $0.60 more valuable instead of $0.50, because Delta has increased. Gamma helps us understand how Delta can change as the ice cream price changes, which is important for people trading options.
Delta and Gamma are two important concepts in options trading that help us understand how the value of an option is connected to the price of the stock (or ice cream, in our example). Delta is like a measuring stick that shows how much an option’s value will change with stock price changes, while Gamma is like a speedometer that shows how fast Delta will change as the stock price changes.
Now, let’s introduce the main characters in our gamma squeeze story: the investors and the market makers. Investors buy and sell stocks and options, while market makers are like helpers who ensure there are enough options for everyone who wants them.
A gamma squeeze happens when lots of investors start buying call options for a specific stock because they believe that the stock price is going to go up while they own the call option contract. When the speculators buy these contracts, the market makers who create and sell them need to balance their own risk because they only want to make money on selling the security. They don’t try to make money speculating. They are “the house” making money regardless of what happens in the market.
(Note: a “Reverse Gamma Squeeze” Happens when investors buy a lot of put options contracts.)
When many investors buy call options, the market makers must buy the stock to balance their risk. This is called “delta hedging.” As the stock price increases, the call options delta also goes up, meaning market makers need to buy more shares to stay balanced. This creates a cycle that can make the stock price rise quickly – and that’s what we call a gamma squeeze!
Let’s think of a real-life example to make it easier to understand. Imagine there’s a popular video game company, and many people think its stock price will go up soon. Many investors speculate it will and start buying call options for the company’s stock, hoping to profit when the price increases. They buy options on the stock versus buying the stock outright because they can leverage small amounts of capital to earn most of the gains still if the stock does, in fact, increase.
The market makers, who create the call options, notice this and start buying the video game company’s stock to balance their risk. This extra buying makes the stock price go up even more. As the price goes up, the market makers need to buy more and more shares to stay balanced. This cycle keeps going, making the stock price rise really fast – and that’s the gamma squeeze in action!
Now, you might wonder if a gamma squeeze can last forever. The answer is no; eventually, the cycle slows down or stops. This can happen when investors stop buying call options or when market makers have bought enough shares to balance their risk. When the gamma squeeze ends, the stock price might stop rising so quickly or even fall back down.
In summary, a gamma squeeze is a fascinating event in the stock market that happens when many investors buy call options, causing market makers to buy the actual stock to balance their risk. This cycle can make the stock price rise really fast for a while, but it doesn’t last forever. By understanding what a gamma squeeze involves, you can become more knowledgeable about the stock market and the factors affecting stock prices so you can make smart financial decisions with your money.
