WSB Finimized: Is The “Reverse Gamma Squeeze” Reddit’s Latest Weapon Against Hated Hedge Funds?

WSB Finimized: Is The “Reverse Gamma Squeeze” Reddit’s Latest Weapon Against Hated Hedge Funds?
Reda Farran, CFA

about 3 years ago4 mins

Mentioned in story

This article is the last in a series we’ve been running all week examining popular trade ideas posted on the WallStreetBets Reddit forum.

What’s going on?

Another day browsing the hidden corners of WallStreetBets to find interesting investment ideas, and a post by user dusty22s caught my attention. Not because it’s particularly popular (it barely has any upvotes), but because of this striking realization: after WallStreetBets traders clubbed together to burn hedge funds shorting their favorite stocks, might they be able to do the same to hedge funds who are long?

Why could it happen?

I explained how “gamma squeezes” work in an Insight earlier this week, but here’s the summary: when an investor buys a call option, the market maker who sold the contract will hedge their risk by purchasing the underlying stock. The more the stock rises toward the option’s exercise price, the more shares the market maker has to buy in order to remain hedged. This obscure dynamic in the market plumbing can create a positive feedback loop of rising stock prices and forced buying by market makers. The resulting spike is called a gamma squeeze. 

But this dynamic also works in reverse. When investors buy put options, the market makers selling those options protect themselves by selling – a.k.a. shorting – the underlying stock. This time, if the price of the shares drops toward the option’s exercise price, market makers have to short more and more shares to remain hedged – and that can create a feedback loop driving the stock lower and lower. Lo and behold, we have a reverse gamma squeeze. 

So that begs the question: after some recent forays pushing shares higher, can WallStreetBets traders band together to drive stock prices down? In theory, yes – by purchasing loads of put options. Adding fuel to the fire is the fact that market makers, on a whole, are net sellers of puts, making the reverse gamma squeeze scenario more likely. Why are market makers net sellers of put options? Because there’s a lot of investor demand for puts as a way to protect themselves against stock price declines.

This is in contrast to call options where market makers, on the whole, are net buyers, making a gamma squeeze scenario less likely. Why are market makers net buyers of call options? Because there’s been a huge increase in the number of investors following covered call strategies, where investors sell call options on stocks that they own as a way to generate some extra income in their portfolios.

In summary, because of the way market makers are positioned, the gamma squeeze dynamic has a bigger effect with put options driving down stock prices than with call options driving up stock prices.

Where could it go wrong?

While forcing a reverse gamma squeeze in a stock is by no means impossible, there are three reasons why WallStreetBets traders might struggle to pull it off.

First, in the normal gamma squeeze scenario, market makers who sell calls are forced to buy more of the underlying stock as it rises toward the option’s exercise price. So even WallStreetBets traders unwilling or unable to purchase options can pile on simply by buying the underlying stock – as we saw with GameStop. This is much harder to do in reverse as few retail traders are allowed to sell shares short and, even for those who can, higher margin requirements for short selling mean it’s tricky to do it in meaningful amounts. 

Second, the unfavorable asymmetry of shorting stocks could put off a lot of WallStreetBets traders. Buying a stock gives you unlimited upside potential while the most you can lose is the amount you paid. Shorting a stock is the opposite: your gains are limited to the amount shorted, but your potential losses are unlimited. Hence why buying stocks rather than shorting stocks is preferred among traders seeking a massive “YOLO” return.  

Finally, the entire GameStop frenzy has led to increased market volatility. And higher market volatility makes options more expensive. This might deter some WallStreetBets traders – especially the more risk-averse ones – from forking out for put options that have capped gains and will probably – like most options – expire worthless. 

Now that Reddit’s finest have figured out they can use gamma squeezes to push a stock rapidly higher – causing pain to short sellers and prompting some to flee the market altogether – they might start targeting hated hedge funds with long positions.

Finimize

BECOME A SMARTER INVESTOR

All the daily investing news and insights you need in one subscription.

Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

/3 Your free quarterly content is about to expire. Uncover the biggest trends and opportunities. Subscribe now for 50%. Cancel anytime.

Finimize
© Finimize Ltd. 2023. 10328011. 280 Bishopsgate, London, EC2M 4AG