Gamma squeeze vulnerability describes a market condition where a rapid price movement in the underlying asset forces option market makers to rebalance their hedges in a way that exacerbates the price trend. This vulnerability arises when market makers are collectively short gamma, meaning they must buy the underlying asset as prices rise and sell as prices fall. The resulting feedback loop can lead to significant price spikes or crashes.
Risk
The risk associated with a gamma squeeze is systemic, impacting not only individual market makers but also overall market stability. As market makers scramble to adjust their positions, liquidity can rapidly evaporate, leading to cascading liquidations and extreme price volatility. This risk is particularly pronounced in cryptocurrency markets due to high leverage and lower liquidity compared to traditional finance.
Mechanism
The mechanism of a gamma squeeze begins with a directional move in the underlying asset price, often triggered by external news or large orders. This movement causes market makers’ short gamma positions to become increasingly sensitive to price changes. The resulting forced rebalancing creates a positive feedback loop, where buying pressure from market makers pushes prices higher, further increasing their short gamma exposure and forcing more buying.
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