During the pandemic, people couldn’t get drunk, hang with their friends, or go golfing, so they replaced those hobbies with options trading. Bloomberg’s Matt Levine calls this phenomenon the boredom markets hypothesis. Here’s Matt explaining:
The weird thing about the coronavirus crisis is that it simultaneously (1) caused a stock market crash and (2) eliminated most forms of fun. If you like eating at restaurants or bowling or going to movies or going out dancing, now you can’t. If you like watching sports, there are no sports. If you like casinos, they are closed. You’re pretty much stuck inside with your phone. You can trade stocks for free on your phone. That might be fun? It isn’t that fun, compared to either (1) what you’d normally do for fun or (2) trading stocks not in the middle of a recessionary crisis, but those are not the available competition. The available competition is “Animal Crossing” and “Tiger King.” Is trading stocks on your phone more fun than playing “Animal Crossing” or watching “Tiger King”? I have no idea, I have never done any of those things, but I gather that for some people the answer is yes.
Because retail traders were all doing the same thing–buying weekly options in hyped-up stocks, market makers had trouble adjusting and often saw their positions overrun.
The primary mechanism behind retail traders getting a few over on option market makers is a gamma squeeze. Gamma is option Greek which measures how rapidly delta changes, allowing you to hedge more effectively.
What is Gamma?
Gamma is like the “delta of delta.” While delta measures how an option price changes given a $1.00 move in the underlying price, Gamma measures how delta changes given the same $1.00 in the underlying.
You can think of it like the “momentum” of delta. All traders are familiar with momentum trading — in which the price of a stock increases faster the more it rises. You can think of Gamma as the momentum of delta.
Gamma is vitally important to professional options traders who surgically manage their portfolio risk. After all, when your delta changes, your exposure changes. If you bought a bunch of 0.20 delta calls and suddenly become 0.70 delta, your exposure just went up exponentially, hence, your risk.
Because Gamma tells you how fast delta changes, it hints at how your position might move in the future.
A good rule of thumb is that when you’re short options, you’re short Gamma and vice versa. Market makers are primarily short options due to the overall demand from options traders to buy puts for protection or calls for speculation.
Because market makers are short options during a significant market catalyst or period of volatility, they’ll often have to hedge in the same direction as the underlying stock price. If market makers are short calls, they’ll have to buy more shares to delta hedge as the underlying stock price rises.
These situations, where the market makers are a sort of “forced buyer,” are the golden goose for many options traders.
What is Gamma Hedging?
Gamma hedging simply refers to this act of continually adjusting your delta hedge as a market maker.
Let’s consider what happens when you buy a call option. Most of the time, a market maker takes the other side of your trade. Market makers are agnostic about the direction of the stock, they’re just aiming to sell you the call at slightly above its intrinsic value. So they hedge their position.
Perhaps you bought a delta 0.40 call. The market maker now has to buy 40 shares of the underlying stock to remain delta neutral. This way, he is only exposed to the volatility aspect of the options trade and not the directional aspect.
However, as we know, delta can change. Say the delta of the given option goes from 0.40 to 0.70. The market maker has to buy another 30 shares of stock.
This is a routine part of a well-functioning market. It generally works fine because, typically, for every person wanting to buy a call, someone is willing to sell a call, buy a put, etc. Markets tend to stay within a state of equilibrium.
But suppose you introduce a group of traders who are buying only short-dated call options into a market at equilibrium. In that case, it gets disrupted, and that’s when a “gamma squeeze” occurs.
The Role of a Market Maker
A market maker provides liquidity to both sides of the market. He is a volume trader and makes money by making thousands of trades that show a small profit. He bids (offers) slightly below (above) what he deems as fair value and makes a tiny average profit on each trade.
Market makers strive to remain market neutral. They don’t care if the market goes up or down or want exposure to that fact. They bet that their judgment of fair value is, on aggregate, close enough to correct for them to profit.
As a result, market makers manage their inventory and ensure they never end up too short or too long. But sometimes, people only want to sell to you, forcing you to provide tons of liquidity to only one side of the market.
What is a Gamma Squeeze?
An entire cottage industry around options gamma and Gamma squeezes sprouted up in response to the rise of retail traders buying call options en masse. Retail stock options volume went from $20 billion in 2010 to $240 billion in 2020, according to Risk.net.
At least in hyped-up names, the options market changed so dramatically that professional traders needed to quickly adapt by understanding the effects these new traders had on the market.
A gamma squeeze occurs when the standard mechanisms of options call buying and market maker delta-hedging gets disrupted. Too many traders are doing the same thing–in this case, buying short-dated call options.
Retail call buying forces market makers to buy stock to hedge their short call position. The market maker share buying pushes up the underlying price, which pushes up the delta of retail’s calls, which creates a feedback loop.
This quick change in delta makes gamma rise, forcing market makers to hedge even more aggressively, just throwing oil on a fire.
Furthermore, as the retail traders make money, they begin putting their foot further on the accelerator and buying more calls, with the allure of making insane gains. Call buying leads to more call buying, and gamma hedging leads to more gamma hedging. This ensures that the underlying stock’s price will soon be divorced from reality.
The most classic example of a gamma squeeze, and primarily responsible for the term becoming part of mainstream financial vernacular, was the GameStop 2021 squeeze. While marked as merely a short squeeze, the options market played a far more prominent role than reported.
On January 28th, 2021, GameStop options registered a put/call ratio of 0.12, meaning 12 puts were purchased for every 100 calls. The vast majority of which were short-dated.
The market makers become the “whales” of the market who are too big to maneuver, allowing swift traders to front-run their order flow.
Gamma is everyone’s favorite option Greek nowadays, and much of the mainstream options trading world has shifted towards trying to exploit market dynamics related to Gamma.
Gamma is the rate of change of delta. It helps market makers and other traders adjust their delta hedges.
A gamma squeeze occurs when market makers are short Gamma in a volatile market and are forced to continually hedge in the direction the market is moving, creating a feedback loop.