The sequence goes a little something like this: traders buy a ton of call options, and they have to buy them from someone (market makers and\/or dealers). These players don\u2019t want to make money by taking the other side of this bet, though. They want to make money through extracting value from every little bit of buying and selling activity that occurs. So when a market maker sells a call \u2014 which would leave them exposed to losses if shares of the underlying company rally a ton \u2014\u00a0they will simultaneously offset that risk by buying a given amount of shares of that company.<\/p>\n
When lots of traders are buying options, they are effectively forcing a lot of buying of the underlying stock at the same time! This buying can put upward pressure on the share price, which forces even more buying from these entities that have no view whatsoever on the stock, but are merely trying to cover their butts.<\/p>\n
Let\u2019s tie in the Greeks: delta is a term that describes how an option\u2019s price is expected to change based on a $1 shift in the price of the underlying asset. Delta will tend to go up as the stock price goes up. When market makers are buying stock after they\u2019ve sold a call (and buying more if the stock rises after that!), they\u2019re delta-hedging. Gamma is the second derivative of delta; it describes how much the delta is poised to change based on a $1 change in the price action. Gamma is at its highest at the point when the option is at the money. This makes some intuitive sense: whether an option is in the money or out of the money will, at expiration, loosely determine whether or not it has any value.<\/p>\n
To sum\/to some: the natural response of market makers in an environment where increasing out-of-the-money call option buying propels a stock price higher, pushing that strike in the money and pushing the stock even closer to a higher strike price where another formerly out-of-the-money call option threatens to be money-good, and so on and so forth. It starts to look an awful lot like a perpetual motion money-making machine.<\/p>\n
A \u201cgamma squeeze\u201d is the technical explanation for how and why these parabolic moves occur. Market makers are rapidly picking up more deltas, which they need to hedge their exposure because gamma keeps accelerating at different, higher points in the options chain. It\u2019s much easier to see this dynamic play a starring role in smaller stocks and\/or ones with constrained float.<\/p>\n
This is something that, while very well known by professional options traders, was \u201cdiscovered\u201d and popularized in the r\/WallStreetBets community in early 2020<\/a> thanks to\u2026 me (whoops). Similar market dynamics played a significant role in the next year\u2019s mania that took shares of GameStop<\/a> to record highs.<\/p>\n