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The Real Squeeze to Be Worried About Isn’t a Short Squeeze, It’s a Gamma Squeeze

A gamma squeeze is a short squeeze taken to the next level; here’s why they’ve become more common and how to avoid them.

As Roaring Kitty, Citadel, Melvin Capital and Robinhood execs began answering questions for the House Financial Services Committee last week, the world of Reddit and GameStop  (GME) - Get GameStop Corporation Report re-entered the headlines. 

The entire saga really hasn't disappeared, but it has shed light on risks even professionals like hedge fund managers face -- risks that can obliterate a portfolio if an investor isn't careful. Over the next week or two, we're going to hear the term "gamma squeeze."

The most pressing question on many investor's minds is, or should be, how do I avoid getting caught in a gamma squeeze? It's very simple. Don't short a stock and don't short call options.

Short squeezes aren't anything new to the markets. The basic idea behind a short sale is an investor borrows a stock and sells it to someone else. The stock loan isn't permanent. Eventually that investor will have to repurchase the stock. Their thesis is they will be able to buy it at a price lower than they sold it and use that lower-priced stock to satisfy their borrow, profiting from the difference.

Read More: When Short Selling Is Done Wrong

The thing is, a stock has a fixed number of shares available to trade. If too many people borrow (short) the share, then a large number of buyers will flood the market attempting to buy the stock, pushing the price way up in what’s known as a “short squeeze.” Since there are no limits to how high a stock can go, it also means there are no limits to how much an investor can lose if they short a stock.

If an investor's losses exceed his or hers account value, or there are no longer enough shares to borrow because of heavy buying demand, the investor who is short the stock can be forced to buy back the shares regardless of the market price in what’s known as a forced buy-in.

With the introduction of options, specifically weekly call options, a short squeeze can be taken to another level called a gamma squeeze. Gamma is a term used among options traders but it adds a wrinkle for even non-option traders that is worth understanding. It's a situation where the tail wags the dog, then the dog wags the tail and it cycles back and forth. But in this case, it is the stock pushing options until the options push the stock. Think of it as the Sisyphus of squeeze trading as the buyers continue to rotate back and forth between buying stock and buying options.

Read More: 7 High Short Interest Stocks That Could Break Out

What happens is we get a stock rising in price. Speculative investors will buy call options, which give them the right to buy the stock at a specific price known as the strike price. The change we're seeing in the market is that an investor can now buy a low-cost, far out-of-the-money call option -- i.e. one with a strike price significantly higher than the current stock price -- that will expire in the near term, maybe the end of the week or the next week. For instance, on GME, there were people buying call options giving them the right to buy GME at $150 per share when the stock was trading at $75 per share, and they only had a few days until the contract expired.

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You might be thinking who would be on the other side of that $150 call? After all, for every buyer, there needs to be a seller. And if there isn't a seller, then the market maker will step in as the seller, at least until they can find another investor to take the other side of the trade. However, when you get the crazy volume of tens of thousands of contracts being traded as we saw with GameStop, there simply may not be enough contract sellers to take the other side of the trade.

But market makers want to make markets, not hold or short option contracts, so they will take action to remain "neutral." Simply put, they will buy a small number of shares in order to neutralize their position, so that they are neither bearish nor bullish.

Read More: Bob Lang writes for Real Money on the mechanics of short squeezes

Even though they may not be buying many shares, however, it still adds buying pressure to the shares. And that starts Sisyphus. The stock price moves higher, which draws in more buyers because they see the price rising. After all, technical and momentum traders love to buy stocks moving up. And then the gamma squeeze begins.

More stock buying encourages more far out-of-the-money call option buying, which requires the market maker to buy stock to protect themselves, which pushes the stock even higher. Rinse. Repeat. Gamma squeeze.

It's not simply the options that cause this type of squeeze; it's the cycle. And when it ends, there's usually nothing but air below the stock, which results in a fall that happens faster than the rise.

The easiest way to avoid getting caught in a gamma squeeze and the subsequent fall is to not short stocks, not short options and not buy a stock in the middle of a gamma squeeze after a huge run higher.

Read More: Bob Lang writes for Real Money on why short selling is necessary

The potential for gamma squeezes is likely to remain in this market for some time now that we have weekly options on many stocks. We're unlikely to see them in large caps and companies with large share floats that are moderate- to high -priced, which means they aren't single-digit stocks. 

Eventually, the market makers will price out the ease with which these strategies can be implemented by more quickly raising the premium on far out-of-the-money call options. That will make it so that the risk of buying those options will be too great for speculators to aggressively attempt to gamma squeeze a stock. But until then, I believe simply avoiding shorting small cap or low-float stocks will be enough to avoid trouble.

Tim Collins is a regular contributor to Real Money, TheStreet’s premium site and provides options trade ideas each day on Real Money Pro, our sister site for active traders. Click here to learn more and get great columns, commentary and trade ideas from Jim Cramer, Helene Meisler, Mark Sebastian, Paul Price, Doug Kass and others.