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How Gamma Squeezes Can Exacerbate Short Squeezes

How Gamma Squeezes Can Exacerbate Short Squeezes

Earlier, we discussed on Bitget Academy what short squeezes are and how they can occur under certain market conditions. If you’ve yet to read the article or need a refresher, you can head over to our Academy page. For those of you who have absorbed everything you needed to know about short squeezes and the GameStop incident, this article will be exploring yet another market phenomenon that can turn the already volatile situation of a short squeeze into an even more unstable condition. These are known as gamma squeezes.

What are Call Options?

Just like understanding short squeezes, to grasp the idea of gamma squeezes, we’ll first have to explore the concept of call options. Similar to futures, options are part of the derivatives family and work along the same lines, although in this case, the holder of the option has the right, but not the obligation, to purchase or sell cryptocurrency at a predetermined price. This means investors will generally have more flexibility when it comes to options. However, to take advantage of this instrument, purchasing an option requires a premium upfront, so any change in the price of the underlying cryptocurrency in your favour will have to cover that premium before generating profits for you. There’ll also be an expiry date, after which your option can no longer be exercised.

For example, if the price of BTC is now at US$16,300 and you predict it will go upwards, you can purchase call options from a seller who might agree on a price of USD$16,500 and a premium of US$20 per BTC. If you buy call options to purchase three BTC at those prices, your premium will therefore be US$60. Subsequently, when the price of BTC goes up to US$16,800, you can buy them at US$16,500 and sell them immediately, making a total profit of US$900. Deducting the premium of US$60, your net profit will be US$840. In the case that the price of BTC actually drops, however, your exposure will be limited to just US$60, as you have no obligation to exercise your call option.

How Call Options Increase the Snowballing Effect of Short Squeezes

As we explained in our article on short squeezes, the phenomenon is essentially created through a snowballing effect where those losing out from short positions are being forced to buy back shares at a higher price, increasing market demand and pushing prices up. This then forces other short sellers to do the same, inflating prices even further. Call options have the ability to make this snowball grow in size even quicker, exacerbating the situation in what’s called a gamma squeeze.

A gamma squeeze often occurs when a stock or cryptocurrency has attracted a large amount of short-dated call options. Investors who, contrary to short sellers, believe that the asset is about to rise in price will have entered into these agreements in anticipation of a surge, and once a short squeeze occurs, the asset price begins shooting up rapidly. To capitalise on this opportunity to buy low and sell high, traders will flock to exercise their call options, increasing buying activity on the market and therefore pushing prices up even higher. As prices surge quicker, more call options are triggered, subsequently creating yet another snowballing effect.

Profiting From Gamma Squeezes Can Be Risky

As with any other significant market shift in direction, profits can be made during a gamma squeeze. Because a short squeeze or gamma squeeze results in prices for the underlying asset to rise sharply, those who enter the market early and manage to buy low will have an opportunity to sell back at a much higher point, generating profits you don’t normally see during normal market conditions. Indeed, this was what happened during the GameStop incident back in 2021, when its stock price surged over 400% at one point, causing immense losses to institutional investors shorting it and massive profits for retail investors going long.

However, any form of trading possesses inherent risk, and with gamma squeezes, timing is absolutely crucial. Because price surges can occur so quickly, traders might not be able to enter the market at the ideal price point. At the same time, since the price of the cryptocurrency in question has been largely inflated by a gamma squeeze and not based on any true, underlying value of the token or blockchain development, the speculation can drive steep price reversals, leaving many investors plagued by significant losses if they didn’t manage to exit the market in time. With this said, traders looking to profit off of a gamma squeeze should manage risk appropriately and make sure to do sufficient research before investing.

Disclaimer: This article is for educational purposes only and is not intended as investment advice. Qualified professionals should be consulted prior to making financial decisions.

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