How Retail Option Traders Are 'Supercharging The Short Squeeze' In GameStop And Other Potential Bubble Stocks

See also: How to Buy GME Stock

The crazy trading action in GameStop Corp. GME and other heavily shorted stocks continued on Tuesday as a tug-of-war between institutional short sellers and online communities of retail traders carries on.

From a distance, the volatility in stocks like GameStop, Nikola Corporation NKLA, Dillard's, Inc. DDS, BlackBerry Ltd BB and Bed Bath & Beyond Inc. BBBY may seem like a dispute between bulls and bears about whether or not these companies have long-term rebound potential. In reality, the trading action has little or nothing to do with the long-term futures of these companies.

The Option Market’s Role: On Monday, there were more than 32 million call options traded on the market, the second-most in a single day in history according to Bloomberg. These call options are leveraged bets that an underlying stock will rise prior to the option’s expiration date.

According to CC Lagator, co-founder of Options AI, retail traders have been aggressively buying out-of-the-money call options in so-called meme stocks or story stocks for months now. These stocks typically represent companies that have extremely high valuations relative to their current underlying businesses.

“That tended to be in names like Tesla, and it already was having an effect on those stocks by creating large areas of short gamma to the upside and contributing to those stocks' rise,” Lagator told Benzinga.

Lagator said retail traders are looking for stocks that have extremely cheap upside calls to buy. When retail traders buy those calls, market makers and institutions selling those calls are essentially then short those upside calls.

“Those short calls create a ton of short gamma for the market makers. As the stock rises towards/through those strikes the market makers need to buy increasingly more stock to hedge their short calls,” Lagator said.

Related Link: 'Peak Stupidity': The End Of The GameStop Short Squeeze Trade?

How A Gamma Squeeze Works: The first step in a gamma squeeze is that one large trader or a legion of small retail traders, such as the Reddit WallStreetBets community, buys short-dated call options in a stock such as GameStop. When they buy these call options, the institutional brokers and investment banks that sell them essentially become short the underlying stock. The more call options the traders buy, the more shares of the underlying stock institutional brokers and market makers must buy to offset their short position.

When an appropriate stock is selected and the call buying is done on a large enough scale, a positive feedback loop is created.

“That gamma effect adds buyer after buyer in the stock, with no one able to short the stock because it is hard to borrow,” Lagator said.

The ideal candidate for this type of squeeze is a heavily shorted stock like GameStop. When forced short covering is also added to the mix, the positive feedback loop is fueled further.

How It Ends: This type of gamma squeeze has worked wonders for the stock prices of GameStop and other heavily-shorted stocks in the short term. Traders that got in on the squeeze early have ridden GameStop shares higher by 552% in the past 30 days, and call buyers have likely far exceeded those returns in that stretch.

Without any underlying value creation in GameStop’s struggling video game retail business, however, Lagator said the gamma squeeze eventually comes to an end and it could get ugly for traders still long at that point.

“Eventually, the short squeeze in the equity itself ends, and maybe that just means the stock goes sideways a bit. What then happens in the options is the opposite effect where all those pumped upside calls that have been hedged...start to decay to zero, meaning the market makers now have stock to sell because they have over-hedged,” Lagator told Benzinga.

Benzinga’s Take: The leaders within the Reddit trading community and other online groups have put a new spin on the pump-and-dump trading strategy by taking advantage of the leverage of the option market. They select short squeeze targets by identifying stocks that are heavily shorted by hedge funds. Then they take advantage of market maker hedging by focusing on the option market rather than buying the stock itself, intentionally triggering a gamma squeeze.

It’s a brilliant strategy, and the traders that get in early enough in the process have likely already made a killing. However, it’s extremely difficult to time entry and exit points of a short squeeze once it has begun, so anyone trading GameStop stock at this point is playing with fire.