Once again, the entire stock market is getting “gamma-squeezed.”
We’ve seen it happen on individual stocks before. Indeed, the entire meme stock craze in 2021 can be defined as a gamma-squeeze event. But, it’s really not supposed to happen with the broad stock market.
Let me explain…
Meme Stock Mania
Let’s go back to the original meme stock mania of 2021. You remember that, don’t you?
Back then, the Reddit-crowd of retail investors would buy far-out-of-the-money call options on stocks like GME, AMC, and BBBYQ.
Market makers would willingly sell the options to the retail investors. They were happy to collect the premium.
But in order to offset the risk of being short calls, the market makers would buy shares of the underlying stock – thereby making a “delta-neutral” trade, a trade that is not dependent on direction but profits as time passes and the option premiums decay.
As more and more retail investors bought calls, market makers had to buy more stock in order to offset the risk of being short calls.
This buying pressure – in the absence of natural sellers of the stocks – forced the stocks higher.
The higher stock prices brought in more call buyers, which then forced market makers to buy more of the underlying stocks, which brought in even more call buyers – and on and on.
This is a gamma-squeeze. And, it continues until folks stop buying call options and/or enough natural sellers of the stocks show up and pressure the price lower.
Then it all unwinds in spectacular fashion.
Gamestop (GME), for example, lost about 80% of its value in just one week in early February 2021. AMC Entertainment (AMC) dropped 70%. Bed Bath & Beyond (BBBYQ) lost 60%.
Like I said, this happens on individual stocks all the time. It’s not supposed to happen with the broad stock market.
But, that’s what’s happening.
Meme Market Mania… Again
It’s largely due to the existence of zero-day-to-expiration options on the major stock market indexes. These are options that expire on a daily basis. Trading in these contracts has increased the size and persistency of the daily moves in the indexes.
Folks have been buying large amounts of daily out-of-the-money call options on the market indexes (SPX and QQQ mostly). Market makers who are selling those calls need to buy the stocks of the underlying indexes, or futures contracts on the indexes, in order to neutralize their short call positions.
That buying pressure – in the absence of natural sellers – is pushing the indexes higher.
This doesn’t happen if there is a bearish counter force. But, the bears have been run over so badly the past several weeks that no one is shorting. No one is selling. So, the market squeezes higher.
I’m Waving My Caution Flag
How long can this keep going?
I have no idea. All I know is that when it stops, the market will unwind in spectacular fashion.
I wrote about this phenomenon last July – just a few days before the broad stock market began a correction that would knock 12% off the S&P 500 over the next three months.
Now, with the old meme stocks catching fire again this week, and with the major market indexes surging to new all-time highs, it feels right to start waving the caution flag again.
Be careful out there.
Best regards and good trading,
Jeff Clark
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