The market maker on the other side of that options trade would have probably used a gamma calculation to help determine how many shares of GameStop to buy in order to set up a hedge.įast forward to January 2021, the GameStop short squeeze is in full swing.
That would have protected the investor from a short squeeze causing a spike in GameStop's price, at the cost of some of the potential profits if the company's shares did continue falling toward zero. That investor could have bought a $15 call option to cover that bet for a fairly cheap price back then. Say an investor shorted 100 shares of GameStop at $10 per share back in October 2020. exercise price of the call is above the price shares trade at when the calls were purchased). So many people had made that decision regarding GameStop that more than 100% of the company's total float had been sold short at one point.īecause of the potential for a short squeeze, some investors who short stocks don't simply sell a stock, but rather they cover their shorts by buying long, offsetting, out-of-the-money calls (i.e. When they expect such bad news, investors may be tempted to borrow and short the stock. In GameStop's case, many people have long expected the company to be forced to declare bankruptcy, thanks to a business model that has been largely disrupted by digital downloads of games. What can create the conditions for a gamma squeeze to occur? It's the slope of the option's delta chart that represents the option's gamma, and that slope is at its steepest - and thus the gamma is at its highest - at exactly that option's exercise price. In the middle, though, that delta chart curves upward, reaching a value of 0.5 and reaching its steepest slope at exactly the option's strike price. An option's delta will change based on how far away the stock price is from the exercise price of the option, and in which direction. For instance, if a call option has a delta of 0.2, its price is expected to rise about $0.20 for a $1 rise in the underlying stock. To understand gamma, you first have to get a handle on an option's delta (another Greek), which represents the expected change in the price of an option based on changes in the price of the underlying stock. Large amounts of that forced buying or selling activity is what creates a gamma squeeze. As a result, as delta changes, market makers with open options positions are often forced to buy or sell the underlying stock to keep their own books properly hedged. The higher the delta, the larger a stock position the market maker will need in order to have an effective hedge against open options positions. Gamma is a derivative of delta (see below). One of those Greeks - known as gamma - is often used by market makers to figure out how much to hedge their bets. It also enables the calculation of a number of risk measures based on that price that are collectively known as the Greeks.
The Black-Scholes model doesn't just spit out a price for an options contract. It's that hedging activity that can create the conditions that make a gamma squeeze possible. On top of that, the market maker will likely use a little bit of that potential profit, along with other capital, to hedge his or her bets by buying or shorting stock, depending on the option in question. The price at which the market maker will actually trade with you generally figures in a bit of a statistical profit based on that pricing model.