What is a 'Gamma Squeeze' versus 'Short Squeeze'

A ‘gamma squeeze’ is like betting on a basketball game but the bookie is also the referee.

I’ve worked as a lawyer in the financial markets for most of my career. Every now and then I’ll write an explainer giving my view of some popular media event concerning the stock market or other financial market. It’s a fairly esoteric world but in an increasingly financialized economy, they are making more of a direct impact on our lives. So I figure I’ll write about it every now and then.

The media event in question: https://markets.businessinsider.com/news/stocks/wall-street-bets-reddit-gamestop-stock-gamma-squeeze-plans-2021-2-1030124858

So Gamestop ($GME) is back in the news, because the stock price has once again shot through the roof. However, this time it is due to a ‘gamma squeeze’ as opposed to the now-well-known ‘short squeeze.’

(If you want some background on the Gamestop short squeeze, I talk to Daniel Dumbrill about it on his YouTube channel, link at the bottom)

OK so what is a "gamma squeeze" and why does it tell us that something is seriously wrong with our financial system? In the shortest one-sentence way to explain: a ‘gamma squeeze’ is like betting on a basketball game but the bookie is also the referee.

Options are derivatives of equities. That means it's a contract with a value that is 'derived' from the value of an 'underlier' asset. An option requires a buyer and a seller to enter. Used to be run like a betting book, prices (i.e. odds) would have to find equilibrium.

The option was a side bet to the main event. IF the price of STOCK goes ABOVE/BELOW the STRIKE on DATE then it pays out. The equity market functioned as an independent entity, the options market was a side bet on the equity market.

So it was akin to a sports bet. There is a whole market of bettors who are judging risk/reward, but the sporting event takes place on its own, independently from this betting.

Then came the Black-Scholes Equation, which discovered that the a buyer doesn't need a seller exactly.

Black-Scholes sets out a programmatic way to determine what a given option contract is worth at any moment in time, in terms of a set number of shares of the underlier. So an options bookie no longer needs to match buyers and sellers. A buyer can buy without a matched seller.

The options bookie aka the 'dealer' just needs to apply Black-Scholes to determine how many shares of stock they need to own at any given moment in time to 'hedge' i.e. offset the equity price risk of their options book.

That means that instead of using market price discovery to find an equilibrium between buyers and sellers of options contracts, the dealer can take any and all orders, even if the entire market is crowding into long call options. The dealer takes the other side for everyone.

But this means that the options market is no longer a side bet. What happens is that the dealer is now actively hedging by buying and selling shares of the underlier. Thus, the options market has a direct effect on the equities market.

This process by which a side-bet market starts to effect the main event is kind of like a bookie taking sports bets and calling in favors to the referees to tilt the game. At first it was a slow process, but now options volumes exceed stocks.

That means that the options market is now the main market, and equity prices are a derivative of the option. What is the main event and what is the side bet has become inverted. What we're seeing is stock prices behaving as a tail wagged by the options dog.

This is why it's impossible to interpret the price movements of $GME without understanding the what's happening in the options market. What's happening is that WSB day traders are piling into out-of-the-money call options.../ 

And as a result, option dealers are having to go out and buy $GME to hedge those call options, many more traders are buying calls than selling calls. There is 'net delta' on the risk book which the traders have to hedge through on-market purchases of $GME stock itself. Which...

... drives up prices. As dealers hedge long calls, they go out and buy $GME, which drives up $GME, which affects the Black-Scholes (risk) models to tell dealers 'buy more $GME' which... drives up prices...

This is the Gamma Squeeze. It's a self-reinforcing cycle, in which totally asymmetric options activity causes dealers to dip into the underlier market to slake off unmatched risk, which moves the underlier price, which positively reinforces more dipping into the underlier...

And that is how $GME can get whipped up back into $150+ territory with absolutely zero underlying news about the value of Gamestop Inc. or anything like that. The price of $GME is simply the outcome of a large speculative betting pool by which dealers don't have to match risk.

There is no way a betting market in Vegas could do this. The idea that betting would affect the outcome of the chance event is anathema to the underlying principles of gambling. But that's how our equity markets work.

So when Liz Warren says stuff like "Wall Street is looking more like a Vegas casino than a financial market" don't believe it. That's an insult to Vegas casinos, which run much more rational risk markets than what we see on Wall Street these days. 

The Gamma Squeeze is a bit systemically worse than the Short Squeeze, because the Gamma Squeeze can be made to happen on any stock. It doesn't require that the stock be heavily shorted. Groups of speculators can form and decide to drive a gamma squeeze on any stock they want.

This has a different character than the Short Squeeze play. This seems to be just straight up manipulation through the use of LEVERAGE. Compared to stocks, options are a way to take levered risk positions, where the payoffs can be much bigger than the upfront cash investment.

This is particularly true of very-out-of-money call options, because the pricing is generally fairly cheap. It's basically saying that the buyer of the option will get no benefit of a rising stock price, unless it rises to a preset strike price well above the current price.

What the Gamma Squeeze play is doing is saying let's find a way for speculators to coordinate which call option contract to pile into, knowing that such one-sided and concentrated buying will have a direct effect on the movement of the stock price. This is a kind of cheat.

All these cheats are made possible by some underlying market structure which is badly designed, and imo it is the ability for dealers to engage in 'active hedging,' i.e. buying underlying shares to make up for the unmatched risk on its options books.

The ability for dealers to actively hedge greatly benefits them for various reasons. These dealers are typically large banks that have prime brokers. By being options dealers, the banks can buy PROPRIETARY STOCK positions, which is generally prohibited by the Volcker Rule.

Not so long ago banks could take their own bets on stocks, but not anymore. They cannot take any market position, except in limited circumstances, and HEDGING is one of those circumstances. This allows the house to buy its own shares, for its own book.

This is called a 'principal position' as opposed to a 'customer position.' This enables the dealer bank to do something very lucrative: LEND SHARES TO SHORT SELLERS.

That's right, there is yet another backdoor connection between options markets and equity markets. By allowing one-sided unmatched options speculation, this creates 'dealer inventory' in stocks, which drives the stock loan market by getting PB's to have own-shares to lend.

I don't think anyone has quite figured how all this works out yet, and it's all very dynamic. When some weird shit happens, it will eventually be traced out as to how these weird inter-dependencies creates a market crisis. But it seems like we're heading into uncharted waters. 

Discussion of the Gamestop short squeeze, among many other topics including Digital Yuan, Bitcoin, war with China, existential crisis, meaning of life, etc…