Bitcoin’s recent rally has been something to see: a 60%+ blast this year alone has led it to raise above its record high of roughly $69,000. Now, it may be on the verge of a truly massive move, up or down, because of a concept called a “gamma squeeze”.
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A call option on bitcoin gives its buyer the right, but not the obligation, to purchase the token at a specific price (the “exercise price”) within a certain timeframe. When investors buy these contracts, the sellers (usually market makers at big financial firms) need to hedge their exposure. The concern from their point of view is that bitcoin will shoot up and prompt those investors to exercise their call options. When that happens, the market makers have to buy the token at the higher price and sell it at the agreed lower one – taking a hit on the difference. To hedge against this risk and essentially cover their bets, market makers buy some bitcoin whenever they sell a call option contract.
But here’s the thing: the amount of crypto that market makers need to hold to remain hedged doesn’t stay the same. It increases when the price of bitcoin rises and causes options that were “out of the money” (i.e. when bitcoin’s price is lower than the option’s exercise price) to become “in the money” (the opposite). Said differently, as the price of the token increases and approaches the options’ exercise prices, market makers are forced to buy more of it to remain hedged. And when there’s a huge amount of call option contracts open, as there are now, all that forced purchasing activity from market makers pushes bitcoin’s price up further, which necessitates even more buying to remain hedged. This self-perpetuating loop is called a gamma squeeze.
This can also work in the other direction. A big drop in bitcoin’s price encourages market makers to sell some of the crypto they’d previously held as a hedge. This can lead to a loop of more price declines and a further unwinding (i.e. selling) of hedges.
Today, the number of bitcoin call option contracts expiring on March 29 has soared (green bar) to 65,000 – way higher than contracts expiring on other dates, according to crypto derivatives exchange Deribit. Most of the money in these call options – covering roughly $4 billion of the token – is clustered around exercise prices between $60,000 and $75,000. And with bitcoin’s price early somewhere in the middle of this range, these options can quickly turn from being out of the money to in the money (and vice versa), making the world’s biggest crypto ripe for a gamma squeeze in either direction.
And then there is the upcoming “halving event“, with the likelihood that it will power the cryptocurrency higher by reducing the number of new tokens in circulation. But this is the topic of another blog post to come…
