When the stock is at the strike price the market maker will usually have at least 0.5 of the position hedged, or 50,000 shares in order to cover off the 50% probability that the call will expire above the strike price and their exposure to potentially needing to deliver the shares to the call buyer. Delta can also be seen as the probability of an option expiring in the money, so for example, an option with a delta of 0.7 will have a 70% chance of expiring in the money. Gamma measures this change.Īs the stock price rises the market maker must keep buying more stock, further fuelling the rally, to adequately hedge.
But if the stock price rises, delta approaches 0.5 at the strike price. The delta may be 0 or 0.1 on a position like this, meaning the market doesn’t need to hedge at all, or they buy 10,000 shares as a partial hedge (delta of 0.1 x 100,000 shares). There is no danger to the market maker because the stock is below the strike price, and not even near it. Assume a market maker is short by issuing and selling 1,000 call contracts (100,000 shares) at a strike price of $10 and the stock is currently trading at $8. Gamma is the change in delta for each dollar the stock price moves.ĭelta tells the market maker how much they need to hedge. For each US dollar the price moves, so will the option. When a stock is trading well above a call option’s strike price then the delta is near 1. When a stock is trading well below a call option’s strike price, then the delta is near 0. For example, a delta of 0.3 means for each US dollar the stock price moves, the option premium will change by 0.3. These terms are both known as ‘Greeks’, and they tell options traders how the option acts relative to the underlying stock.ĭelta is how much the option price will move relative to a move in the underlying stock. This is where gamma comes in, and to understand gamma, we need to understand delta. This ironically has the effect of pushing the stock price up – the very thing they don’t want. To mitigate this, they start buying the stock to hedge their short options position. If the price of the stock rises, they face large losses. When many people buy call options from a market maker, the market maker is effectively taking on a large short position in the stock.
This other party is usually a market maker – traders who work for an exchange, bank or company and are mainly looking for small steady profits rather than accumulating a massive speculative bet (although they may do this as well). When an options trader or investor buys a call option, someone needs to be on the other side of the transaction and be willing to sell them the 100 shares. A call option is the right to buy 100 shares of stock at a given price, called the strike price, within a given amount of time. To understand a gamma squeeze, a bit of options trading knowledge is required.
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