Large movements in SPACs have been drawing attention in recent weeks, but traders should be cautious around those moves, James ‘Rev Shark, Deporre said recently in a Real Money article.
“If you have been recently trading some of the fastest-moving stocks in the market, you have probably heard the phrase "gamma squeeze,” Deporre noted in the Real Money piece. “Traders have found some situations in the SPAC sector where there has been a very high amount of redemptions when a SPAC deal is being concluded. In some cases, as many as 90% of SPAC shares have been redeemed by holders.”
Aggressive traders have been targeting these situations because the very small float linked to these redemptions, combined with a gamma squeeze, can trigger huge moves in the market. “Shares of IronNet Cybersecurity (IRNT) have more than doubled in a couple of days due to this dynamic,” Deporre said.
This is how a gamma squeeze develops, according to Deporre.
“When a broker sells a call option to someone, they are not looking to take the other side of the trade,” Deporre said. “The broker just wants to earn its commission and has no desire to carry any risk. The way that they do that is to sell the call to the buyers and then immediately buy an equal amount of common shares. That leaves the broker net flat. If the call is exercised, then the broker just delivers the shares that it bought to hedge the trade, and the transaction is closed.”
Deporre notes the broker doesn't care about the price of a stock. “It just keeps paying whatever price is necessary to buy the required stock and offset the risk associated with the calls it is selling to customers,” he explained. “If there is enough buying of calls and a relatively small float, this can create a positive feedback loop. The more calls that are bought, then the more stock that is bought and the higher the price of the stock goes.”
Sooner or later, the scenario will unravel and the stock will decline significantly. “It’s easy to understand how this dynamic can cause a stock to fly higher as buyers pile into short-term calls and a thin stock is pushed higher and higher as brokers hedge their positions,” Deporre said.
Rev Shark also noted there’s a “very high risk” linked to these trades as they can unwind so quickly. “This is the trade that caused a fund run by William Hwang to suffer a $20 billion loss in a matter of a few days,” Deporre said. “So if you’re playing this game, then be aware of the high risk.”