Personal Finance & Money Asked on June 28, 2021
I am learning the concept of Gamma Squeeze from The Motley Fool. Under the "Why options trading can create stock volatility" section, it is mentioned that for options trading:
chances are that you are not trading with another individual investor, but rather with a market maker
Then I have following thought. Consider a stock XYZ with 1 million floating stocks at the price of 100. If there is a trader selling 200,000 put options of strike price 100 expiring the coming Friday and the stock price fell to 99 by the end of Friday, then the put option would be ITM, and will be automatically exercised. Does that mean the market maker needs to buy 200,000X100 XYZ shares and sell them to that trader?
But there are only 1 million shares available on the market, how could the market maker get 2 million shares out of thin air?
What I want to know is: if the number of option contracts is so high that it exceeds the total number of floating stocks in the market, what would happen?
To a large degree, the article is is correct but it presents a topical approach and ignores the bigger picture. Let's start out with the statement:
When you open an options contract, chances are that you are not trading with another individual investor, but rather with a market maker. You and your counterparty (typically the market maker) are likely creating the options contract -- both the assets and the liabilities they entail -- out of thin air, within the structure of standardized contracts.
That's not true on several accounts. First, new contracts are only created "out of thin air" when both parties are taking opening positions. That results in an increase in open interest. For the majority of near term GME options (where the speculators play), the daily volume exceeds the open interest. That means that a lot of contracts are just changing hands (not being created).
The market maker isn't always the counterparty as the article suggests. In such a situation, retail and institutional traders are involved in GME in every possible way at all prices. Buyers and shorters of the stock. Buyers and sellers of the puts. Buyers and sellers of the calls. It's impossible that chances are that you are not trading with another individual investor, but rather with a market maker, unless it's an arb with the MM in the middle (see below).
Yes, a gamma squeeze is real but the article implies that the market maker was on the hook for a ton of risk at all times. Unmentioned is that market makers have a number of ways to lay off risk. For example, if the market maker sells you a 20 delta call, he could buy two 10 delta calls.
There are other ways for a market maker to lay off the risk. For example, an arb called a conversion. Suppose there's a put seller and a call buyer of the same series option. If the prices are attractive, the market maker can buy 100 shares, buy the put and sell the call to the aforementioned call buyer in the article and the market maker has zero risk. Yes, he's buying stock, helping to fuel the short squeeze. On the other hand, if there's a put buyer and a call seller, he does a reverse conversion, aka reversal, and does the opposite (short stock, short put and buy call).
Yes, the short squeeze was real and of great magnitude but the article is myopic and has some errors.
Correct answer by Bob Baerker on June 28, 2021
Consider a stock XYZ with 1 million floating stocks at the price of 100. If there is a trader selling 200,000 put options of strike price 100 expiring the coming Friday and the stock price fell to 99 by the end of Friday, then the put option would be ITM, and will be automatically exercised. Does that mean the market maker needs to buy 200,000X100 XYZ shares and sell them to that trader?
In this case, since the market maker is the owner of the options, it has the choice of whether to exercise them or not. It is hard to imagine why the market maker would choose to exercise all of the options in this case, since that would require the market maker to deliver an impossibly large number of shares. Instead, they would presumably buy as many shares as they can at a good price, exercise the corresponding number of contracts, and choose to let the remaining contracts expire in the money without exercising them.
Come to think of it, it's hard to imagine why the market maker would be willing to buy 200,000 put options in the first place.
Answered by Tanner Swett on June 28, 2021
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