Coming to a theater near you this weekend is the comedy-drama "Dumb Money", which bills itself as “the ultimate David vs. Goliath tale”, telling the story of the everyday retail investors who thumbed their noses at some of Wall Street’s titans and drove a stock-buying frenzy that briefly turned GameStop into the world's hottest company. So this seems like a great opportunity to go over one of the biggest (and least-understood) factors behind GameStop’s dramatic surge – and explain how you might spot similar situations elsewhere.

But first, a quick recap.

GameStop's long-suffering stock saw an unprecedented surge in January 2021 – at one point closing at more than 1,700% higher than its starting value for that month. This dramatic rise was driven mostly by a group of retail investors from Reddit community r/wallstreetbets, who conspired to challenge the big-name hedge funds who were betting against the beleaguered stock. But GameStop’s “short interest” (the number of shares bet against it) remained relatively flat during that period, suggesting factors other than investors covering their short positions might’ve been driving the stock higher. This is where the concept of a “gamma squeeze” comes in – and I’d wager it played an even bigger role in GameStop’s surge.

What does all this mean?

Well, a short squeeze happens when a stock price rises and forces the investors who hold “short” positions on it to cut their losses and buy back in. If there are a lot of them, this buying activity drives the price even higher. A gamma squeeze takes things one step further: here, a high number of open options contracts forces yet more buying of the underlying stock.

Let’s break that statement down. When you buy an option, you’re more likely to be trading with a “market maker” than another individual. Market makers work at big financial firms, such as investment banks. And when you buy the option, you’re creating a contract with that counterparty. If it’s a “call” option, you’re getting a right (but not an obligation) to buy the underlying stock at a specific price within a certain timeframe – and the market maker is agreeing to sell it to you accordingly.

From the market maker’s point of view, the big worry is that the stock price shoots up. If that happens and you exercise your call option, the market maker would have to buy the stock at a high price, sell it to you for the agreed lower one – and take a big hit on the difference. To hedge against this risk, market makers immediately buy some of the underlying stock whenever they sell a call option contract.

And the amount they buy is by no means random: instead, market makers use advanced mathematical formulas to calculate an option’s delta. Delta is the expected change in the option’s price relative to changes in the price of the underlying stock. For example, if a call option has a delta of 0.3, then its price should increase by around $0.30 for every $1 rise in the underlying stock.

This figure essentially tells market makers how much of the underlying stock to buy for every call option that they sell. The higher the delta, the more they’ll need to purchase to adequately hedge against potential price movements.

As the chart below shows, delta moves from 0 to 1 as the option goes from “out of the money” (where the underlying stock price is below the option’s exercise, or “strike”, price) to “in the money” (the opposite). When it’s 0.5, the option is perfectly balanced “at the money” (the stock’s price is equal to the option’s strike price). Understandably, the option’s price behaves more like that of the underlying stock as the latter’s price rises and the option moves into the money – but it isn’t so sensitive to changes in the underlying stock price when it’s well out of the money.

A call option’s delta, relative to the underlying stock price. Source: Chuck Saletta.

Note the middle part of the graph. When the underlying stock’s price approaches the option’s exercise price, the option’s delta increases rapidly. This is reflected in the option’s gamma – a figure that tells us how much an option’s delta changes when the underlying stock price shifts. Gamma is highest when the option is at the money: it’s at this moment of parity that the option’s delta is most sensitive to any swings in the price of the underlying stock.

Delta, remember, tells market makers how much of an underlying stock they need to buy to hedge their options-selling risk. So when delta increases – that is, when the underlying stock price approaches an option’s exercise price – these market makers are forced to buy more of the underlying stock to remain hedged. And if there’s a huge amount of call option contracts open, all that forced buying activity from market makers will push up prices further in a “gamma squeeze”.

So how does this relate to GameStop?

Just like market makers, one of the biggest risks for investors shorting a stock is that its price shoots up instead. To hedge this risk, short sellers often purchase out-of-the-money call options on the stocks they short. If the price of the stock leaps, then the gains from their call options will help offset their shorting losses – capping the total potential loss from the trade, which would otherwise be unlimited.

This is exactly what GameStop’s short sellers did. They shorted, let’s say, 100 shares at $10 per share back in October 2020, buying a $15 call option to cheaply hedge their risk. Then, all of a sudden, an army of small retail traders started purchasing GameStop shares and call options, pushing its stock price up toward $15 and causing those call options’ delta to boom. Market makers were forced to increase their hedges accordingly by buying more shares themselves, sending their price even higher. Retail investors, seeing their predictions of a short squeeze fulfilled, piled further in – and the volume of call options open caused a major gamma squeeze.

Why should I care?

Now that you’re aware of this phenomenon, you can use it to help look out for the next potential big squeeze. The recipe for a truly enormous rise à la GameStop contains some important ingredients.

First, there’s a high “short float” combined with low trading volume. The short float is simply the number of shares currently being shorted as a percentage of the total shares available for trading. The higher this ratio, the more extreme the potential short squeeze, as a wider proportion of traders will be competing to close out their shorts if the price rallies. You can view this ratio for any stock on Yahoo Finance (click on the “Statistics” tab and look for “Short % of Float”). Alternatively, you can also view a list of US stocks with the highest short float here.

Trading volume, meanwhile, is like a fire door: if everyone’s trying to get out at the same time, a smaller door means it’ll take longer – increasing the sense of panic. The “days to cover” ratio (number of shares shorted / average daily volume) indicates how long it’d take shorts to cover their positions – and the higher this ratio, the greater the upward pressure on price when they do so. You can easily calculate it yourself (a ratio above 4 is considered high), or screen for stocks with these characteristics using certain websites, like this one.

Second, there’s a bull thesis. It’s worth remembering that GameStop’s share price was already on the up well before it began trending on Reddit. Investors’ ears began to perk up in August 2020 after the contrarian investor made famous by The Big Short built a significant stake in the business.

Third, there’s rising interest from retail traders. Recall that small-time retail investors played a huge role in GameStop’s surge by banding together to cause a short and gamma squeeze. You can browse through the r/wallstreetbets forum yourself to get an idea of which stocks are currently trending with the retail trader crowd, or use online tools (like this and this) to see the most mentioned stocks on the forum.

Fourth, there’s high open interest in out-of-the-money call options. This is the final ingredient that takes a stock from a good short squeeze candidate to a strong gamma squeeze contender. Open interest indicates the total number of option contracts currently out there at a given exercise price – and it’s a figure readily available from sites such as Yahoo Finance (enter a stock ticker, click on the “Options” tab, select the contract month, and look for the “Open Interest” column). You can also find ideas by using this tool to screen for stocks that have experienced the highest recent increases in open interest.

I’ll end with a word of caution, however: gamma squeezes can also work the other way round. A falling stock price causes option deltas to decrease and encourages market makers to sell some of the underlying stock they’d previously held as a hedge – potentially leading to further price declines. Bear in mind that old investment adage: high potential reward means high risk. Good luck, gamma squad.