The GME Gamma/Short Squeeze
Table of Contents
1. Overview
In a short squeeze a rising stock price causes short sellers to cover thier position to limit losses. To cover short sellers need ot buy, but this purchase pushes up the stock causing more losses to other short sellers who have not yet exited thier trade. This causes more short covering (stock purchases) which further causes short seller losses, and the cycle continues. Moreover, this cycle can be exaerbated by derivative positions as highlighted below.
1.1. Short Interest
The likelihood of a short squeeze is increasing the the proportions of a firm's shares which are sold short. This proportion is known as short interest.
1.2. Derivatives and Short Positions
Market participants can be short the stock without actually short selling the stock itself. If you sell a call option on a stock, and hold no other position in the stock, you will lose money as the stock increases.
2. Delta Hedging Calls
Often option sellers, particularly financial intermediaries, will sell call options without wating to make a directional bet. So they have to hedge out the risk that the stock price will increase. This is termed Delta Hedging.
Assuming a model like Black-Scholes we can calculate the sensitivity of the option to changes in the stock price. We call this sensitivity the option's Delta. For example, if a call option's Delta is 0.20, then if the stock increases by $1, the option's value will increase by $0.20.
Importantly, an option's Delta changes as the stock changes. As a stock's price increases, the Delta of the call options on that stock also increase. This means anyone Delta Hedging must buy stock. These stock purchases to Delta Hedge have contributed to the recent short-squeeze in GME. We'll take a look at how the Delta for GME calls behaved below.