Video game retailer GameStop (GME 7.58%) has been experiencing breathtaking volatility throughout the month, particularly yesterday when the stock was up as much as 145% before dipping into the red by 6% and finishing out the day up 18%. Trading on the stock was halted 9 times throughout the day due to volatility.
Much of the recent activity has been attributed to WallStreetBets, a growing community of retail traders on Reddit. The bullish thesis is that Chewy co-founder Ryan Cohen, who has accumulated a significant stake in GameStop as an activist investor and secured a seat on the board of directors, will be able to help engineer a turnaround and accelerate the company's digital transformation.
Much has also been written about a massive short squeeze, where short sellers scramble to buy shares to close out their positions. That pushes the price higher, which can cause other shorts to bail on their positions, creating a cycle of intense buying pressure. With short interest of around 140% (since shares can be loaned out multiple times), conditions were primed for a historic squeeze. But that isn't the only type of squeeze that's been driving unprecedented volatility.
Speaking Greek
In addition to trading activity for the underlying stock, there has also been a surge in options activity. For example, Bloomberg reports that there were a record 913,000 call options traded on Friday, well above the open interest (the total number of contracts that existed as of the previous day) of approximately 400,000. Here's how options volumes are contributing to the enormous moves.
When an investor buys an options contract, it is typically from a market maker whose role in the market is to provide liquidity. Market makers stand ready to buy and sell all sorts of securities with the goal of profiting off the bid/ask spread. But since options are leveraged derivatives, market makers are potentially exposed to incredible levels of risk. In order to mitigate this directional risk, market makers hedge their options positions by trading in the underlying stock.
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Options traders should be familiar with the Greeks, which measure the impact of different factors on pricing. I'll only discuss the two that are most relevant here: delta and gamma. Delta ranges from 0 to 1 and represents the expected change in the options price if the underlying stock moves by $1. At-the-money (ATM) options will tend to have a delta of around 0.50, and delta approaches 1 as the option moves deeper in-the-money (ITM). Gamma estimates the change in delta if the stock moves by $1, effectively measuring the acceleration of delta as the option gets closer to ITM. Gamma is highest for ATM options.
Another way to interpret delta is that it loosely represents how many shares of stock the option contract will behave like. Since an options contract represents 100 shares, having a call with a delta of 0.50 would be similar to owning 50 shares -- either position would gain $50 if the underlying stock increased by $1.
For example, if an investor buys an ATM call contract from a market maker, that market maker is now short 1 contract and has a position of negative 0.50 delta. To hedge that risk, the market maker will typically go and purchase 50 shares of the underlying stock. If the stock continues to rise, the market maker's delta position also becomes increasingly negative at a faster rate due to gamma, requiring more buying, which pushes the stock even higher still, and so forth. This phenomenon is known as a gamma squeeze and the feedback loop resembles a regular short squeeze.
Gamma squeezes can be particularly potent when investors are purchasing a high volume of out-of-the-money (OTM) contracts, which WallStreetBets traders are doing en masse. If the stock begins to rise to approach the strike price, that is when the delta acceleration (measured by gamma) is the strongest.
Two simultaneous squeezes
Options market makers have large portfolios that consist of various types of contracts at different strike prices and expirations. They will usually aggregate their combined delta across all options positions while trading the underlying stock in an effort to keep their overall delta as close to 0 as possible. Market makers are not especially interested in making directional bets on where a stock might go. This is a dynamic process called delta hedging that requires constant adjustment.
Back to GameStop. The roller coaster that we're witnessing is a combination of all of these factors: A bullish fundamental thesis has created a significant influx of interest from retail traders, which has caused a short squeeze and gamma squeeze to occur simultaneously.
