The “David and Goliath” war between Wall Street traders GameStop (NYSE: GME) and other very shrinking stock hedge funds and social traders are experiencing astonishing volatility as sales continue to grow. witnessing one of the battles. media Reddit website.
GameStop shares rose to an incredible level in January – with a market capitalization of $ 18.41 billion – following a conversation on social media that the company’s stock has risen 1,000 percent in the past two weeks.
On January 4, GameStop shares were worth just $ 17.25. But in recent days, the stock has risen more than 500%.
At the start of the rally, daily traders identified GameStop short sellers as their main enemy, hoping to make a profit by forcing traders to close their positions.
But this crazy trading move has nothing to do with the long-term future of other stocks like GameStop and BlackBerry (NYSE: BB), AMC (NYSE: AMC) and Virgin Galactic (NYSE: SPCE), which are losing money. .
Analysts have described this epic short squeeze as high as short interest ratesgamma compression.He wrote.
But before we go any further, let’s first briefly mention what compression is.
A short squeeze means inefficiency in the market, which means that stocks of very short-term stocks will grow rapidly because there are not enough stocks that can be sold to new buyers.
A short position basically it is a way for traders to bet on stocks falling. Traders borrow shares from a brokerage firm or other trader and sell them on the stock market.
If the stock price goes down, they buy back the shares, use it to pay off the debt with the lender, and pocket the difference as a profit.
Now let’s move on to gamma compression.
What is gamma compression?
“Gamma compression” is a trading terminology that leads to the purchase of a large number of calls, which leads to stock prices, which leads to the purchase of more calls, the rise in stock prices, and so on. .
As the price of securities increases, the value of calls, which is a type of option, increases.
To start gamma-squeezing, a small group of retailers or a single large trader buys short-term call options in the underlying fund, pledging a stock rise.
Once you buy these call options, the investment banks and intuitive investors who sell them actually become the main stocks.
For example, traders on Reddit’s WallStreetBets forum ask each other to buy a very large number of GameStop call options at very high prices, also known as money with very low stock sales.
If traders need to buy more call options, market makers and institutional brokers will be forced to buy more shares of the underlying stock to cover their short positions.
If the calls find themselves “in the money,” market makers can cover their losses.
Like a short squeeze, when the stock price starts to rise and traders increase their call positions, market makers are forced to buy the main stock, so its price has gone up.
Investors who sell or write a call are hoping for a price drop, but as with the short term, the downside may be technically endless, as stocks may continue to rise instead of falling to zero.
If the liquidity of a stock is low, the latter can lead to a further increase in the share price, forcing brokers to buy more shares as their exposure value increases as the stock price approaches the strike price of the call options.
This relationship creates something called “gamma compression,” which can cause some investors huge losses.
For example, two hedge funds that pledged a drop in GameStop shares were thrown in the towel.
One of them, Melvin Capital, closed its short position on GameStop, manager Gabe Plotkin told CNBC that the hedge fund was suffering huge losses.
As a result, its supporters, Point72 Asset Management and Citadel, are currently raising about $ 3 billion to hold it.
Citron Research also announced in a video on YouTube that most of GameStop’s short position was closed “with 100% damage in the ’90s.”
Gamma, Delta connection
You’ve probably heard of these Greek letters, but you may not know exactly what they are or how they relate to gamma compression.
Options traders often use Greek letters to refer to their positions: gamma, delta, theta, and vega.
These Greeks refer to simple concepts that help traders better understand the risks of a potential reward and option position. They show the sensitivity of the option price to the movement of its underlying reserves, the change in the expected variability, and the decrease in the value of time.
Let us discuss the relationship between gamma and delta.
Delta measures the rate of change in the price of options on the change in the price of the underlying stock. The .40 delta means the option price will increase by 40 cents for every $ 1.
Delta does not change in proportion to the share price because it is not a nonlinear function.
When the stock price changes, the Gamma Delta measures how it changes. Simply put, gamma tells traders how much the option delta needs to change as the price of the underlying stock rises or falls.
In most cases, the option premium is a small fraction of the price of the underlying stock. But if the option is in cash after the expiration date, its owner will assume the delivery of the main shares and must pay in full for the shares. However, option traders often postpone the selection to the next month or sell it to avoid payment.
Gamma compression can be a source of significant variability and instability worth exploring.
The ideal stocks for gamma-squeezing are companies like GameStop, which have been greatly reduced by institutional investors and hedge funds.
This type of compression is based on the hedging efforts of short sellers.
Investment banks and brokerage companies, which are the biggest sellers of options, should block their positions. They often adjust the set amount depending on the delta of the option.