Market Sees 7 Record Options Days, Stoking Gamma Squeeze Fears

U.S. equity markets are flashing warning signs after a record wave of call option buying forced dealers into a hedging frenzy that threatens to unwind, mirroring the dynamics that fueled the meme stock craze and raising questions about the rally's stability.

"This is the first time that both risk appetite and momentum performance have been at such elevated levels since the start of 2000," a Goldman Sachs team led by Andrea Ferrario said in a note, calling the current backdrop "exceptional."

The S&P 500 has seen seven of its largest call option volume days in history over the past 10 trading sessions, a surge that has helped push the index up 2.8% for the month despite Friday's 0.9% drop. This activity has been concentrated in technology shares, which have sent the Nasdaq soaring over 5.2% in May, while the VIX index of volatility has remained unusually elevated during the rally, closing Friday above 18.

The primary risk is a "gamma squeeze," where options sellers are forced to buy stocks to hedge their positions, artificially inflating prices. With major index options expiring Friday, the removal of these hedging flows could trigger a sharp reversal, a risk compounded by stubbornly high inflation and oil prices that have seen Brent crude rise more than 9% since last Friday.

A Rare Confluence of Risk

The speculative fervor has pushed Goldman's Risk Appetite Indicator (RAI) to 1.1, a level only seen 2% of the time since 1950 and the highest since 2021. When combined with the current high-momentum environment, it creates a situation last seen just before the dot-com bubble burst. The bank's analysis shows that since 1962, there have been eight similar episodes where both risk appetite and momentum were this elevated; a bear market followed within two years in three of those instances.

"Historical analogues point to more limited upside for the broad equity market and more volatility for momentum," the Goldman analysts said. While they caution that elevated readings are not sufficient to time a market peak, the historical precedent is a cause for concern.

Narrow Rally, Broad Concerns

The rally has been notably narrow, driven largely by speculative call buying in a few mega-cap names like Nvidia, which has seen its own "pre-earnings squeeze," according to analysis from Michael Kramer of Mott Capital Management. This has amplified moves across the entire S&P 500 in a way that is "largely mechanical."

This dynamic, where call option sellers must buy the underlying stock to hedge their risk, creates a feedback loop: rising prices beget more call buying, which forces more hedging and pushes prices higher still, detached from fundamentals. It's a phenomenon that defined the meme-stock craze, but is now playing out at a benchmark level. The concern is that when these options expire, as they did Friday, the dealer hedging pressure evaporates, removing a major source of artificial support for the market.

This article is for informational purposes only and does not constitute investment advice.