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When a stock looks vulnerable, hedge funds often turn to short trades.
A short trade involves borrowing shares and then selling them. You aim to buy them back at a lower price. That way, you can return those shares to the original holder and keep the difference as profit.
For example, you might borrow 100 shares and sell them at $100 a share. If the stock falls to $90, you can buy your shares back and return them to the lender. You keep the $10 per share profit (minus any fees).
But this popular strategy comes with sizeable risks…
The stock might see unexpected positive news – like a surprise earnings upgrade or rumors of a takeover. If the stock surges, short sellers can get caught on their back foot.
Take the same example. You borrow 100 shares and sell them at $100 per share. But if the stock price rises to $110… $120… $130… or more, you’re out of pocket the difference.
You can end up chasing the stock higher as your losses pile up. The more “shorted” a stock is, the greater that risk becomes.
This scenario is referred to as a “short squeeze.” But it doesn’t just apply to stocks.
This phenomenon also occurs in the world of options. And it can lead to some extraordinary movements in the underlying stock price…
Hedging Positions
When you buy an option, your trade is typically matched up with a market maker.
A market maker provides liquidity by offering both bid and offer prices on a wide range of call and put options. That enables traders to readily enter and exit their option positions.
Key to a market maker’s operations is strict risk management. And one way they do that is by hedging their positions.
Otherwise, if they sold a bunch of call options (without hedging their risk), they could face massive losses if the stock rallies sharply and call option buyers exercise their options.
In this case, the market maker could need to buy shares at a much higher price than the option’s strike price to deliver the required stock.
To avoid that situation, the market maker closely monitors the market action.
If the stock underlying their sold call options starts to rally, they need to jump in to buy shares to hedge their option position. This leads to another type of squeeze.
And the hotter a stock is running, the bigger this “squeeze” becomes.
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Gamma Squeezes
The more call options a market maker sells, the more shares they will need to buy if the stock price starts to rally sharply.
They can get caught in a real bind…
As a market maker, they need to provide liquidity as more call option buyers come into the market. At the same time, they need to keep buying the underlying stock to protect their position.
This can turn into a loop, driving the stock price sharply higher.
This incessant buying causes the option’s delta to rise. That means the option becomes more sensitive to changes in the underlying stock price. Gamma gauges the speed of this change – the quicker this change, the higher the gamma. That’s why this kind of action is referred to as a “Gamma Squeeze.”
Then when you combine excessive short selling in a stock along with a gamma squeeze, that can lead to explosive moves.
Think back to what happened with GameStop (GME)… Back in early 2021, the stock price rallied from $5 to around $120 in a matter of days.
But it reversed just as quickly. Only traders who got out quickly were able to bank serious profits from such a ferocious move.
Another often-cited example is AMC Entertainment (AMC). In early 2021, it surged from around $2 to over $300 (split adjusted) before collapsing. These meme stocks represent some of the biggest short squeezes in market history.
Yet there are other tradeable opportunities even with less extreme moves…
They may feel like slow motion compared to AMC and GME. The setups can take weeks or even longer to play out. But they can still hand you tidy profits.
To capture them, you need to look out for a stock or index that’s in an emerging strong uptrend or on the verge of breaking higher.
You also want to see that coincide with a high number of open call option positions (high open interest).
As the wall of call options gets hit as the stock price rallies, that gives the stock price tailwinds as the market makers move to hedge their positions.
Put these two factors together, and you can bank some serious profits in quick time.
Happy Trading,
Larry Benedict
Editor, Trading With Larry Benedict
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