What is gamma compression?

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The phrase, barely seen in stock transactions in recent years, has become a term frequently dispersed in traditional and social media.

In gamma compression, the price of a stock rises transiently depending on whether an investor buys many options to drive up the prices of certain stocks due to the option sellers having to hedge their trades on. the underlying stocks.

But how does it work?

How does gamma compression occur?

When an investor buys a stock option, there is a good chance that a market maker has sold it. A market maker does what its name suggests: it creates markets by selling options to people who want to buy options, and it buys options from people who want to sell them. They profit from the difference between the bid price and the ask price or the spread.

Now, if a stock has multiple traders buying call options, because there is speculation or market analyst predictions that the stock will recover, market makers will take action to hedge their risk. .

In other words, they will take steps to prevent them from selling naked options (options sold without shares or cash previously set aside to fulfill the option obligation at expiration). These options run the risk of a large loss due to a rapid price change before expiration.

This is where the compression begins.

Market makers will buy stocks in order to protect themselves from a potentially massive loss. In other words, they will buy the underlying stock in order to have net exposure.

How many shares are they buying?

Now we are speaking Greek.

Market makers base the volume of stocks they buy on the “delta” of the option they’ve sold. Delta is the exchange rate of the price of options against the change in the price of the underlying stock. For example, a delta of 0.75 means that if the price of the underlying stock increases by $ 1 per share, the option on it will also increase by $ 0.75. Delta is a linear function, which means it will not change proportionally over the course of the stock.

The higher the delta, the more a market maker will have to buy shares to cover their positions.

Meanwhile, gamma refers to the rate of change of the delta. Simply put, the closer the option is to the money, the higher the gamma rate.

Imagine this scenario.

A market maker sells four out-of-the-money (OTM) calls to a retail trader. An OTM is when the strike price of the call option is higher than the current market price of the underlying stock. They buy stocks based on the delta of that option to minimize their risk. A stock option that has a current price can have a delta of 0.75, while distant OTM options can have a delta of 0.50. Option purchases force brokers to buy the underlying stock, which can cause the stock price to rise.

And now a loop is created. As the stock moves up towards the money, the market maker needs to buy more stocks to make sure they either offset their risk or are net. As mentioned, brokers and dealers are driven by commissions and won’t want to hold a long or short trade. This causes the action to continue to rise, known as gamma compression.

Gamma cuts can have a huge influence on the equity market when investors buy a high volume of OTM contracts. If the stock continues to rise towards the strike price, this is when the delta acceleration (measured by gamma) is strongest.

Another phenomenon similar to gamma compression is short compression. In this scenario, short sellers frantically buy stocks to close their positions. The buying frenzy pushes the price higher, which can cause other shorts to bail out their positions, creating a cycle of intense buying pressure.

Conclusion

Investors who wish to personally manage their stock portfolio will come across a variety of stock market metrics that can guide them in determining the course of a company’s stock price. Learn more about concepts such as short floats.

What is gamma compression?



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Last updated: July 21, 2021

Posted: January 29, 2021


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