The real pressure to worry about is not short pressure, it is gamma pressure
As executives from Roaring Kitty, Citadel, Melvin Capital and Robinhood began answering questions from the House Financial Services Committee last week, the world of Reddit and GameStop (GME) – Get a report reinstated the titles.
The whole saga hasn’t really gone away, but it has highlighted the risks that even professionals like hedge fund managers face – risks that can wipe out a portfolio if an investor isn’t careful. Over the next week or two, we’ll be hearing the term “gamma squeeze”.
The most pressing question on the minds of many investors is, or should be, how to avoid getting caught in gamma pressure? It is very simple. Don’t sell stocks or sell call options.
Short presses are not new to the markets. The basic idea behind a short sale is that an investor borrows a stock and sells it to someone else. The stock loan is not permanent. Eventually, this investor will have to buy back the shares. Their thesis is that they will be able to buy it at a lower price than they sold it and use that cheaper stock to satisfy their loan, taking advantage of the difference.
The point is that a stock has a fixed number of stocks available for trading. If too many people are borrowing (short) the stock, then a large number of buyers will flood the market trying to buy the stock, pushing the price up in what is called a “short squeeze” . Since there are no limits to the height of a stock, it also means that there are no limits to what an investor can lose if they sell a stock.
If an investor’s losses exceed the value of their account, or if there are not enough stocks to borrow due to high demand to buy, the investor who is short of stocks may be forced to repurchase the shares regardless of the market price in what is called a forced membership.
With the introduction of options, especially weekly call options, a short press can be taken to another level called gamma compression. Gamma is a term used by options traders, but it adds a wrinkle, even for traders without an option, that is worth understanding. This is a situation where the tail wags the dog, and then the dog wags its tail and back and forth. But in this case, it’s the stocks pushing the options until the options pushing the stocks. Think of it as the Sisyphus of squeeze trading as buyers continue to alternate between buying stocks and buying options.
What is happening is that the price of the shares is going up. Speculative investors will buy call options, which will give them the right to buy the stock at a specific price called the strike price. The change we are seeing in the market is that an investor can now buy a low cost, away from the money call option – that is, an option with a significantly higher strike price than the current share price – which expire in the short term, perhaps at the end of the week or next week. For example, on GME, there were people who bought call options giving them the right to buy GME at $ 150 per share while the stock was trading at $ 75 per share, and they only had a few days before the contract expires.
You might be wondering who would be on the other side of that $ 150 call? After all, for every buyer there must be a seller. And if there is no seller, then the market maker will step in as the seller, at least until he can find another investor to take the other side of the trade. However, when you get the insane volume of tens of thousands of contracts traded like we’ve seen with GameStop, there just might not be enough contract sellers to take the other side of the trade. .
But market makers want to make markets, not hold or sell option contracts, so they will take steps to stay “neutral”. Simply put, they will buy a small number of stocks in order to neutralize their position, so that they are neither bearish nor bullish.
Even though they may not be buying a lot of stocks, it still adds buying pressure on stocks. And that begins Sisyphus. The share price rises, which attracts more buyers as they see the price rise. After all, technical and dynamic traders love to buy stocks on the upside. And then the gamma compression begins.
Over buying of stocks encourages buying out-of-the-money call options, forcing the market maker to buy stocks to protect themselves, pushing the stock even higher. Rinse. Repeat. Gamma pressure.
It’s not just the options that cause this type of compression; this is the cycle. And when that ends, there is usually nothing but air under the butt, which results in a fall faster than the climb.
The easiest way to avoid getting caught up in gamma compression and the ensuing downfall is to not sell stocks, no short options, and not buy a stock in the middle of a compression. gamma after a huge rise.
The potential for gamma compression is likely to remain in this market for some time now that we have weekly options on many stocks. We are unlikely to see them in large caps and companies with large, moderate to high price floats, which means they are not single digit stocks.
Ultimately, market makers will assess the ease with which these strategies can be implemented by increasing the premium on far-from-money calls more quickly. This will cause the risk of buying these options to be too great for speculators to aggressively attempt to squeeze gamma action. But until then, I think just avoiding shorting small cap or low float stocks will be enough to avoid the problems.
Tim Collins regularly contributes to Real money, TheStreet’s premium site and offers options trading ideas every day on Real Money Pro, our sister site for active traders. Click here to learn more and get great columns, comments and exchange ideas from Jim Cramer, Helene Meisler, Mark Sebastian, Paul Price, Doug Kass and more.