r/wallstreetbets vs Wall Street
An explanation of the underlying mechanics behind the recent rise of GameStop: short and gamma squeeze.
r/wallstreetbets is a top 20 Global Hedge Fund with 4.9 million followers under management and not one boring research report in sight*.
Recently, a bull (optimistic) case regarding GameStops’ future performance had started to form.
It really became news after RC Ventures, an entity managed by Ryan Cohen, disclosed a large position and assumed three board seats. At the time, $GME was trading at ~$20 per share.
Since then, the stock has traded at a high of ~$483+ per share and captured the public imagination.
So, how did this happen?
There are two dynamics at play: a short squeeze and a gamma squeeze.
Short squeeze
This occurs when there is a lack of supply and an excess of demand for the stock due to short sellers (like Melvin Capital in this case) being forced to buy stock to cover their shorts.
Gamma squeeze
It is a bit more complicated. Let’s simplify it.
A gamma squeeze is all about options contracts and their indirect impact on the underlying stock.
When you buy a call option, someone has to sell you that option contract. You pay a premium for a commitment to deliver the underlying stock at a future date for the strike price of the option.
In the background, the seller (called a "market maker") has to cover their risk exposure. If the stock rises above the strike price, the seller will have to buy the stock at the market price and sell it to you for the strike price, incurring a loss.
To hedge this risk, when the market maker sells the option, they also go into the market and buy a bit of the underlying stock. The amount of stock they buy is based on the "Delta". It is the ratio of how much the option price moves relative to a $1 move in the underlying stock.
"Gamma" is the rate of change of the "Delta" of the option.
As Delta and Gamma rise, the market makers risk factor increases. They have to buy more stock to hedge the risk of the option being exercised in the money (i.e. with the underlying price above the strike price).
So here we have the (simplified) makings of the gamma squeeze.
As call option purchasing volumes suddenly surged (thanks to r/wallstreetbets and Elon Musk), market makers had to purchase a lot of $GME stock to hedge.
This set in motion a self-fulfilling prophecy.
As the market makers rushed to purchase $GME stock to hedge their exposure, this drove the price up. As the price of $GME went up, the Delta and Gamma of $GME call options rose.
This meant market makers had to buy more stock, further driving up the $GME price.
So to summarise, we had:
A short squeeze: short-sellers frantically buying the stock to cover their shorts and
A gamma squeeze: call option market makers frantically buying the stock to hedge their exposure.
*not really