Gamma Squeeze Case Study: Nvidia

When everyone wants in on the upside squeeze, call options become more expensive and put options get cheap. Did that just happen with Nvidia?

• Gamma plays a role in the day-to-day price movement of stocks.
• Gamma squeezes can happen to the upside and the downside.
• Maybe Nvidia was a negative gamma squeeze.

What is a gamma squeeze?

We’ve all seen the MOASS (mother of all short squeezes) headlines for AMC Entertainment Holdings (AMC) and GameStop (GME), but do gamma squeezes exist for more liquid stocks or even for the market as a whole?

The short answer is yes—gamma plays a large role in the day-to-day swings in the market.

Gamma is the rate of change of an options delta given a move in the underlying stock. Short options have negative gamma while long options have positive gamma.

How gamma works

As options get closer to at-the-market (ATM) and in-the-money (ITM), the options delta exposure increases. Gamma exposure is highly dependent on expiration, and shorter duration options have much higher gamma exposure. In a near-term expiration, say a weekly or daily expiration, ATM options can go from 50 delta to 100 delta rather quickly on relatively small moves in the underlying. That’s gamma. For further dated options, that change is much less violent, and the option might go from 50 to 55 delta.

The second aspect of gamma is the value of the stock itself.

As a stock goes up, the delta of the option increases in notional value. Meaning, if you are long 100 delta at $50 a share, that position has a notional value of $5,000. If the stock goes to 70, that is now a $7,000 notional value position. So not only does gamma effect exposure to the shares, but the actual size of the position can also get increasingly large the higher the stock goes. This tends to accelerate the upside movement as the overall exposure increases. That is why gamma squeezes tend to be to the upside.

This is flipped to the downside where stock prices fall—notional exposure also falls—but that can still add fuel to the downside movement.

Mechanics of market makers

For the most part, traders are generally long delta. Most people trade for the outcome of the market going up. That means generally, most traders are short puts and/or long calls.

As traders sell puts, market makers buy stock (because they are long the puts) to hedge upside risk because they are short delta on the long puts.

When a trader buys a call, the market maker is short that call and thus must buy shares to hedge that exposure.

Generally, the more interest that comes in on one side of the trade , the more expensive those options become. When everyone wants in on the upside squeeze, call options become more expensive and put options become cheap.

The mechanics of a downside gamma squeeze

In a vacuum, let's say the market is overweight long delta positions, meaning most traders are short puts or long calls. Let's say 20 delta for each position

That means the market is long 20 delta via a short put, and 20 delta via a long call and the market maker is long 40 shares to hedge that exposure (delta neutral). All the long delta bids up the market, but the market maker is net delta neutral.

What happens when the stock doesn’t move as much as expected, maybe like in Nvidia (NVDA)?

The call buyer loses delta and value quickly and looks to sells out of that call which is now a five delta. The market maker has to adjust by selling five shares of stock. The put seller takes profits on the put that is now a five delta, so the market maker has to sell five more shares. So now the option traders are out, and the market maker is long 30 shares of stock….

With the stock up 7%-10%....

Profit taking time! With no position to hedge, the market maker goes back to delta neutral by selling out those shares. That's net 30 shares of fresh unhedged short delta on the market.

All that selling drives prices lower, in the same way the gamma squeeze happens to the upside so, too, can it happen to the downside!

What do you think? With stellar earnings, share buybacks and raises in guidance, is this what happened in NVDA? Let me know on twitter @tradernickybat

Click here to read more about The Stocks That Made the Biggest Moves the Last Time Nvidia Reported Earnings

Nick Battista, tastylive director of market intelligence, has a decade of trading experience. He appears Monday-Friday on Options Trading Concepts Live. On Wednesdays, he co-hosts Johnny Trades. @tradernickybat 

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